Dividend stocks are great but you can generate extra dividends from stocks by selling covered call options. Dividend yields on stocks that I buy generally range from 2 – 5%. This is the dividend sweet spot where the dividend yield is high enough to make it worth it but not too high that it’s too risky. For example, I currently own Target Corp and the current yield is about 4.5%! The yield is high enough that it pays me about $1,000 per yer in dividends to hold it but not too high that it’s at risk of being cut.
I like to generate extra income from my stocks by selling covered calls against the shares I own. Last year I made a 70%+ return on my alternative investment account. You can see my trades and strategy to see exactly how I did it.
What’s a Covered Call?
A covered call is when you simultaneously buy shares in a stock and sell a call option against those shares. A covered call option gives the buyer the right, but not the obligation, to buy your shares at a designated “strike” price in the future. You’re not a buyer in this case. You’re selling the right for someone to buy your shares from you at a designated price in future.
Here’s an example of a covered call:
You go into your options brokerage account and buy 1,000 shares of Whole Foods Market (WFM) at $35 a share. You sell 10 call options against the shares you own that expire 6 months out at a $35 strike price. For this, you get paid $1,500 in option premiums ($150 premium per contract times 10 contracts). One option is equal to 100 shares of the underlying stock. That’s how you get 10 call options to sell in this case.
What happens now? You own $35,000 in Whole Foods Stock but your upside is capped. You get the dividend that Whole Foods pays on its stock but this is really low at 2%. You’d earn about $350 in dividends over the next six months, but you sold the call options to give you an extra $1,500 in income! If the stock is flat over the next 6 months, you get $350 in dividends plus $1,500 in options premiums for a total return of 5.3% or 10.6% annualized. The amount you receive is determined by the greeks (delta, vega, gamma, and theta) which is the topic of an entirely different post.
What’s the Catch With Covered Call Options?
Covered call options limit your upside in the stock and only cover you a limited amount on the downside. In the above example, if Whole Foods stock price went down to $30 per share at the end of six months, you’d be holding a $5,000 paper loss and a realized gain of $1,850 ($1,500 options premiums and $350 in dividends, which are treated differently for tax purposes). If the stock rises to $40 per share, then you will only receive $35 per share and the option income. You miss out on that $5 rise in the price of the stock.
You can see that selling covered call options limits your downside risk and caps your upside potential but you can manage both of these. There’s a ton of flexibility in choosing which strike prices to sell your options at and the amount of time you want to elapse before they expire. I regularly trade covered call options that expire a month into the future at a strike price above the price they’re currently trading. I just did this with Target stock. Target got hit hard but my downside wasn’t as bad because I sold $60 strike call options and collected a premium.
What’s the Best Way to Invest in Covered Call Options?
People I talk to who want to get started selling covered call options don’t know where to start. They not sure which stocks to use when doing this method. They also don’t know how much to allocate to position. There’s a call options blog that I’ve followed since 2009-ish run by Jeff Partlow. This guy is a retired engineer who trades covered calls and posts all of his trades in detail. Thanks Jeff for sharing your trading data with the world. If you want to learn about real trading in covered call options, go to Jeff’s blog and check it out.
There are some best practices you can implement when you go to sell covered call options. I’ve run into different scenarios that you could benefit from and share them here:
1.) Buy stocks to sell covered calls against that you wouldn’t mind owning for a long time. Don’t chase high volatility stocks just because you’ll get more money in options premiums. There’s a reason for this. The stock could implode on you. This has happened to me. It hurts. You don’t want to lose a bunch of money chasing volatile stocks. What I do is make a short list to see which stocks I want to own.
2.) Look at the options premiums you’ll get for each different stock. After I figure out which stocks I wouldn’t mind owning, I look at the premiums that I can get for each stock at different expiration dates. I use the CBOE for this and sometimes Google Finance. I like to get around a 3% option premium if I’m selling the near-month strike. For example, I’ll buy $10,000 in the oil ETF USO and then sell the near-month call option, collecting $320 for the month.
3.) Figure out the time frame of the option and the strike price that makes the most sense for you. Some people sell covered call options for six months out. The premiums are larger this way but there isn’t as much time decay (theta). I really like time decay because it reduces the price of the options, making it easier to buy back the covered call for a profit. This is really a personal preference. Do you want to make a trade every month or several a year? I found that keeping the expiration date within 3 months the best for my preference.
Covered Call Option Conclusion
Covered call options are not the get rich quick method of investing. They’re a conservative method of generating extra income from the stock you already own. Using this method really works for the retail investor. The key is just to start now. You’ll learn as you go and you can even trade in a virtual account until you get a good grasp on trading. Best of luck in your covered call trading and let me know if you have any questions. You can comment below or email me by entering your email in the box below.