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Creating Cashflow: Using Covered Call Strategy To Pay You Cash

May 29, 2008
I'll assume in this article that you already have the basic understanding of stocks and options. If not then it would be worthwhile to read about these investments first. The covered call strategy brings together stocks and options to form a third strategy...a cash flow strategy. The covered call strategy has a number of benefits that makes it an essential element of your wealth creation arsenal, namely it's:

* Simple and quick to implement
* Easy to understand and track
* Produces fantastic cash returns on your capital
* Helps protect your portfolio from market fluctuations
* Fairly conservative...i.e. it's not a high risk strategy
* A fairly hands-off investment once made which frees your time to concentrate on other things

So what type of returns should you expect from the covered call strategy? Well let's examine the strategy and example first because this strategy has a range of possible returns. But before we rush out and implement this strategy I would like to highlight to you that the covered call strategy should only be used by those that already invest or intend to invest in stocks. Investors should not buy stocks simply to implement this strategy for one simple reason...there are better strategies available to you. That is not to say that the covered call strategy does not work for in this context...it does...it is just to say there are better strategies available. However, if you have a stock portfolio or intend to then the covered call strategy is a fantastic way of generating excellent extra income and at the same time lowering your investment risk.

Most investors simply purchase funds (whether actively managed or passive index trackers) and take a totally hands-off approach. Some more adventurous ones invest directly in stocks also in the hope that over time they'll be able to enjoy watching their stocks rise in value. Their returns, also referred to as their payoff, is shown by a 45% line on a payoff diagram.

Informed investors...wealth creators...apply a different strategy.

The covered call strategy generates extra income by selling call options on stocks you own. You can think of it like renting your shares, much like you would rent out an investment property. Unsophisticated "investors" buy stocks and don't rent them out. Would you buy and investment property just for it's capital return and not rent it to someone to generate an income for you? Of course not...well the same applies to stocks.

When I say the word "options", which are derivatives, many people instantly think risk. If you find yourself thinking these types of thoughts you don't know options, and derivatives in general, well enough and you need to. Any investment is risky if you don't know what you're doing. As a former professional derivatives trader I know that derivatives need not be feared, but they must be respected. You need to thoroughly understand what you're investing in if you ever hope to be wealthy. Ignorance is not bliss!

Selling, also known as writing, calls on stocks is not risky. It's a conservative investment strategy. In fact, it is much less risky than just investing in stocks by themselves.

The mechanics of the covered call:

The covered call trade is a combination trade whereby you own a certain amount of stock and you sell call options of the same value. As the seller of the call options you receive a cashflow (the premium) from the buyer. You are effectively selling to the call option buyer the upside benefit of the stocks above the option strike price. You've agreed to sell your stock for a specific price by the option's expiration date. They in turn pay you the premium for that benefit.

You are still exposed to the possibility of the stock price falls, but this is reduced by the premium income from the sold call, which is why it's a more conservative strategy that owning just straight stocks.

Your potential income is also limited, as you cannot earn more than the capital increase in your stocks up to the call option strike plus the income from the sold calls. Above the option strike the buyer will exercise their option and you will have to sell them your stocks at the option strike price.

Covered call example:

Let's say you purchased 1,000 XYX stocks for $50 each, totalling $50,000 in May and you sold 10 June $55 call options for $2.50 each, which expire 4 weeks from now. If XYZ stock goes above $55 to say $60 by the June expiry date you will be "exercised" and have to sell your stock to the option buyer for $55, which will be below the new June market price of $60.

Your compensation for this is the $2.50 premium on each call. Now the 2.50 call is actually $250 because the option in this example represents 100 shares. In the UK and Europe the multiple is usually 1,000, while the US is usually 100. Since, you've sold 10 options your total premium is $2,500, representing a 5% return on your $50,000 investment over 4 weeks (which is an amazing 89% annualized return!).

If the stock price falls below $50 your stock losses will be partially compensated by the extra $2.50 income from your sold options. This is why it's a more conservative strategy than just holding pure stocks. If the stock remains at $55 you will receive your $2.50 and no capital gain returns on your stocks. Anywhere between $50, where you bought XYZ stock, and $55 where the option strike is, you will receive the same $2.50 and an increasing capital return on your stocks.

The maximum return you can hope for is always where your option is exercised. At $55 and above you will receive $2.50 in option premium and $5 in capital appreciation on your stocks. This is a total of $7.50 in 4 weeks, or 15% (which is a truly amazing 515% compound annualized return!).

Covered call variables:

The key variables are how long in the future do you sell you options, and what strike should you sell?

The further you look into the future the higher the sale price for an option. For example, in our XYX call option example the June $55 call was selling for $2.50. The July $55 call would be selling for slightly more than this, say $3.50. However, what tends to happen is that as you look further into the future the increases become smaller and smaller, so the August $55 call might only be only $4.00. So to get the maximum daily benefit from selling a call you should sell calls nearer to expiry, say up to maximum of 60 days. You can calculate and compare alternatives at the same strike by looking at the "per day" income. So in the case of our $2.50 option it would be paying us $0.09 per day ($2.50/(4*7), which is much higher than the $3.50 option return of $0.06 per day ($3.50/8*7).

The choice of strike is a more difficult question and depends largely on your view of the future movement of the stock. The higher the option strike you sell the lower the premium you will be paid, but the benefit is the less likely it will be exercised so you could earn more if the stock price increases. So where the $55 call was selling for $2.50 the $60 call might be selling for $1.00. If the price of the XYZ stock rises to say $60 you would earn $7.50 in the case of the $55 calls ($5+$2.50) and $11 in the case of the $60 calls ($10+$1).

The downside of the higher strike calls is that you loose more and more of your protection as you move to higher and higher strikes. For example, if the price of XYX dropped from $50 today to $47.50 at expiry, in 4 weeks you would have broken even on the $55 call as your $2.50 loss on the stock would be fully offset by the $2.50 option premium you've earned. However, in the case of the $60 call you would lose $1.50.

A good rule of thumb balance of downside protection and upside gain is to sell slightly out-of-the-money calls like the $55 call.

Another good rule of thumb is the strategy of buying your calls back if you can purchase them for 25% or less of the original sale price because the stock has fallen in price, and then reselling new calls for the original price. For example, say the price of XYZ stock falls from $50 to $45 and you can buy the $55 calls back for $0.50 and resell the $50 calls for $2.50. You have effectively increased your option return by $2.00 to a total of $4.50 almost entirely offsetting the $5 (i.e. 10%) fall in the stock price.

Covered calls for your wealth journey:

One of your key aims on your wealth journey is to generate a passive or portfolio income that will exceed your expenses. When you've achieved this you are no longer dependent on your job for an income and you can concentrate on building you wealth rather than working for someone else. You may not have a wealthy lifestyle but you are self-sufficient.

The wealthy sell calls on their existing portfolio, but those on the wealth journey may not have that luxury. In their case they may actually buy stocks so they can sell options to generate fantastic incomes returns. However, as I stated at the beginning the covered call strategy may not be the best option strategy to implement if you do not have an existing portfolio. That is not because it does not work, but because there are simply better strategies. However, let's examine it anyway in this context.

Let's say you're able to accumulate $100,000 in cash perhaps from your investments or your home. Your $100,000 cash would allow you to buy $100,000 worth of stocks and sell the equivalent value of calls. If they generated a 5% monthly return for you, like our example, that's $5,000 per month or $60,000 per year. This is before any capital appreciation or compounding is taken into account on your stocks. Those who want to take the wealth journey need to use strategies like this to give them the cashflow they need to live and invest, which provides you with the freedom to concentrate on finding more income producing opportunities.
About the Author
Emlyn Scott is the founder of Rich1Percent , investor and wealth creation author. He is a wealth creation and finance expert with 4 post graduate qualifications and has amassed a multi-million dollar investment portfolio.
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