Using Buy-Writes to Generate Income

 

As Close to Free Money as You Can Find

Using Buy-Writes to Generate Income

Double the Yield on Dividend Stocks!

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"Nothing in life is free!" Many of us learned that expression at an early age, and I strongly agree with it. If anyone promises me free money, I run the other way. That said, if you own individual stocks such as Bank of America or Facebook, I regularly recommend an options strategy in Cabot Options Trader and Cabot Options Trader Pro that's as close to free money as you can find.

I will tell any investors, whether they're my parents or friends at a cocktail party, that in this virtually zero interest-rate environment, they need to use options to create extra yield in their portfolio.

Here's an example: If you had invested exclusively in the S&P 500 ETF (SPY) last year, you would have finished the year down 0.81%. But if you had applied the very basic options strategy called a Buy-Write, you would have easily beaten those results.

The Chicago Board of Options Exchange (CBOE), which is where I traded for nearly a decade, created an index to track the performance of a hypothetical Buy-Write strategy on the S&P 500. This strategy, which is extremely conservative, finished 2015 up 5.24% vs. the loss of 0.81% for the S&P 500.

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A Buy-Write-also called a Covered Call-is a strategy in which the trader holds a long position in a stock and sells a call option on the same stock in an attempt to generate income. For example, if I own 100 shares of Coca-Cola (KO), I could sell one call against my stock position. When I sell that call, I receive compensation because I'm giving up potential upside on my stock position.

And if you execute the Buy-Write strategy on dividend paying stocks, you can create double the yield!

Let's take a look at a scenario of how the Buy-Write strategy works using dividend stocks. Many savvy investors use Buy-Writes on high dividend stocks to gain two sources of additional income while holding the stock. For this exercise, I will look at how a stock in Chloe Lutts Jensen's Cabot Dividend Investor portfolio would have performed in 2015 with a Buy-Write strategy.

Chloe currently has General Motors (GM) rated as a BUY.

General Motors closed at 35 on December 31, 2014. For this exercise, I theoretically bought 500 shares of GM on the first trading day of 2015, January 2. At the same time I bought the stock, I sold five January 40 Calls for $1.50 (Each option is equivalent to 100 shares, so when a trader sells one call for $1.50, he actually collects $150.)

Let's break down the scenarios of this trade:

My capital outlay on the stock trade was $17,500 for the purchase of 500 shares of GM at 35.

I collected $750 with the sale of five January 40 Calls. (The math behind this is 5 x 150 = 750.) The $750 is immediately credited to my account.

I will collect $552 from the dividend payment on my 500 shares of stock over the course of the year.

Here is the graph of the potential profit and loss on the GM Buy-Write:

If GM closes unchanged from my original purchase price of 35 on the call's expiration on January 15, 2016, I will collect the $750 from the sale of the calls and the $552 from the four dividends and I continue to hold my 500 shares of GM. Between the call sales and the dividends, I would collect an extra $1,302, for a yield of 7.44%. The 7.44% yield was created because the stock closed unchanged on the year.

If GM closed at 40 or above, I will make $2,500 in stock appreciation on my 500 shares, plus the $750 I received for selling the January 40 Calls and the four dividends of $552.

However, because I sold January 40 Calls, if GM closed above 40 on the expiration of the calls, I might have been taken out of my stock position by the owner of the calls, who has the right to buy the stock from me. But in 2015, between the stock appreciation, the call sales and the dividend, I would have made $3,802-a profit of 21.72%.

Buy-Writes are an outstanding way to create extra yield if you hold individual stocks. And executing the strategy on dividend stocks is a way to get double the potential yield. While a Buy-Write limits the potential upside if the stock makes a big move, for many investors, yields of 7.44%, and 21.72% in stocks like GM are home runs.

If you would like to learn more about executing Buy-Writes on dividend paying stocks, check out my basic options advisory, Cabot Options Trader. For a limited time, we're extending our Year-End sale, where you can test drive the advisory at 50% off. Click here for more details.

Experienced options traders can find Buy-Writes as well as more sophisticated options trades in Cabot Options Trader Pro. Visit our website at www.cabot.net find out more about Cabot Options Trader Pro advisory.

Your guide to successful options trading,
Jacob Mintz 

Chief Analyst, Cabot Options Trader and Cabot Options Trader Pro


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