An Easy Way to Double Your Yield
How Do Covered Calls Work?
A Good Covered Call Candidate
Retirees often live on income from their investments, or use it to supplement other income sources like Social Security. For these investors, the past seven years have been challenging, because yields on traditional income-generating investments are at historical lows.
And now, with one Fed member saying this week that the pace of rate increases will be "shallow," yield is likely to remain elusive for years.
As a result, many investors have been forced to "stretch for yield," a phrase that means buying riskier or more volatile assets than you would usually consider because the yields are good.
That's meant huge interest in "alternative" investment classes like Master Limited Partnerships (MLPs) and Real Estate Investment Trusts (REITs), but also huge losses for investors when these risky investments don't work out.
Another yield-boosting strategy that's increased in popularity is writing covered calls on dividend paying stocks. This strategy doesn't have to be high risk; it carries no inherent risk of loss and can be used with very conservative stocks (although taking on more risk will generally mean higher reward).
And while covered calls aren't really hedges, they can reduce risk in a way, by building an income cushion into existing positions.
How Do Covered Calls Work?
A call option has two parties: one investor who sells, or "writes" the call option, and one investor who buys it. The writer agrees to sell a stock at a specified price, the strike price, in the future. If he already owns the stock, it's a covered call. (If he doesn't, it's a naked call, which is much riskier and which I won't discuss here.)
The other party in the transaction is the buyer. She is buying the right (although not the obligation) to purchase the stock at the strike price in the future.
Because you're selling someone the right to buy your stock away from you at a higher price, it's safest to write covered calls on stocks that you don't expect to move up in price much while you own the call.
Calls are a good way to earn extra income from stocks or sectors that are in sideways trends, either because of industry pressures or macro factors like exchange rates.
Let's look at an example, using a covered call on Walmart (WMT).
WMT is currently trading around 81 and is in a three-month-old downtrend, while on a longer-term basis its trend is sideways. I'm not advising buying WMT, but if you own it, it's a good covered call candidate today. You don't have to sell your position, but you can take advantage of this period of sideways movement to generate a little extra income.
Right now, I can sell a May 15 call option on WMT with a strike price of 85 for 31 cents per share. Options are sold in lots of 100, so selling one call option would earn me $31. In exchange, the buyer has the right to buy 100 shares of WMT stock from me at $85 per share anytime between now and May 15. If WMT trades up to 85, this is likely to happen, and I'll lose my investment.
But if WMT stays below 85, I get to keep my stock and the $31 premium I earned for writing the calls.
If you're willing to take on a little more risk, you can earn a lot more.
The current bid for the same calls with a lower strike price of 82.5, for example, is currently 88 cents per share. Or you can sell calls with an 85 strike price, but they don't expire until June 19. Because the likelihood of WMT reaching 85 by June 19 is greater, the current bid for those calls is 76 cents per share. That's like receiving an extra dividend and a half from WMT this quarter.
In general, you can earn more by either selling longer-dated calls or calls with a strike price closer to the current price.
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There are also long-term call options (called LEAPS for Long-Term Equity AnticiPation Securities) that expire in January 2016 or January 2017. You can earn $2.54 per share today by writing January 2016 LEAPS with a strike price of 85, but the chance of your stock being called away in the next nine months is pretty high.
Part of the reason premiums aren't higher is that writing covered calls on dividend paying stocks is a popular strategy, and has grown more popular as the era of near-zero interest rates has dragged on. So options on the most widely held dividend stocks are priced accordingly.
Selling calls on Verizon (VZ) or AT&T (T), for example, will earn you only pennies unless you're willing to sell calls with a strike price that is very close (within a dollar or two) of the current price. Utilities, which usually have low volatility, also offer meager bids for most low-risk options contracts.
However, writing options can be a very low risk way to boost your yields here and there, when appropriate. While they won't protect you from drops in price, you can still sell the stock any time (you just have to close out the call as well).
And options can make it a little easier to hold a sideways trending stock, while doubling or tripling your dividend income.
If you would like to learn more about options or have someone to guide you, consider taking a risk-free subscription to Cabot Options Trader. Chief Analyst Jacob Mintz will guide you step by step on executing options for maximum profit.
Your guide to a secure retirement,
Chloe Lutts Jensen
Chief Analyst, Cabot Dividend Investor