Covered Calls
The Ideal Strategy To
Supercharge Your Portfolio

Covered calls are an excellent way for dividend investors to supercharge their dividend portfolio because selling call options can be very profitable because the investor who buys those call options must be right on three things.

1. The direction of the market (up or down).
2. The magnitude of the move (how far the stock must move to go above the strike price).
3. The time that it will take for the market to move as far as he thinks it will move (the move must happen before the option contract expires).

Being wrong on any one of these three parameters means the option buyer will lose his option premium.

The dividend investor who sells calls must only be right on one of the three parameters.

The odds are in your favor.

You sell someone a call option for a stock that you already own. This gives the call option buyer the right to buy your stock at the option’s strike price by the expiration date.

You make money on the credit paid to you. You also continue to be paid dividends from the stock you already own.

Example: Bristol-Myers Squib stock trading at $25.60 in June pays $1.28 per share in annual dividends ($0.32 per quarter). You can sell an out-of-the money call with a 3-month expiration (BMY SEP 28 call) for $0.23.

This raises your quarterly income from your BMY stock by 71%. Talk about supercharged!

If the stock price rises above $28 you will be forced to sell it. However you make a $263 profit and receive your quarterly dividend!

If the stock price falls the credit received from the call acts to reduce your cost basis giving you more time to react before having to sell your stock.

The call option you sell is considered “covered” because you already own the stock you are obligated to sell. But you only have to sell your stock if the option expires in-the-money. That's a big if.

This strategy is considered less risky than a naked call because naked calls involve promising to sell something you don’t already own. Naked calls are considered more risky because you don’t know how much money you need to shell out if the naked call expires in-the-money and you have to buy the stock to settle your end of the contract.

Covered calls are considered a conservative strategy. So conservative that you can sell covered calls within many IRAs.

But don’t be fooled. There are risks which we’ll talk about later.

Possible Outcomes For Your Stock

Three things can happen if you do nothing between the time you sell the covered call and the expiration date. There are more outcomes if you take action, which I’ll describe later.

1. The call option expires worthless.

   The covered call expires worthless if it expires out-of-the-money. You keep your stock and pocket the money you made when you sold the option contract.

   Example: You own 100 shares of FRO (Frontline, LTD) which you bought for $32.15 per share. The stock’s price is $33.00. You sell one JULY 37.50 Call for $1.25 in June (1-month from expiration) for a credit of $125 minus $7 in commissions.

   If the stock’s price is less than $37.50 at expiration in July, you will keep the credit and the stock.

2. The stock is called away from you.

   The option is exercised and the stock is called away from you if the option expires in-the-money.

   You keep the original premium from selling the option.

   You keep the dividends paid to you up to that point.

   You get the money from selling the stock at the strike price.

   You forfeit any additional profit from the stock’s price being above the strike price.

   Using the same example, if the stock’s price at expiration in July is $40, the stock will be called away from you. You will keep the original credit ($125 minus commissions). You sell the stock for $37.50 for a capital gain of $535. You forfeit the additional profit since you are selling the stock for $37.50 when the market is asking $40. Your overall gain on this stock is $660, a gain of about 20% on the $3,215 you invested. Pretty good profit.

3. The option is exercised early.

   The stock is called away from you before the expiration date. Everything mentioned in #2 happens, but it happens before the expiration date.

   Why would this happen?

   Deep-in-the-money options have little time value. The person who bought the option decided to exercise his option early to reduce his carrying costs.

Assignment: Risk Or An Opportunity?

I suspect there are dividend investors who fall in love with their stock because of the rich dividend yield and do not want to allow the stock to be called away.

Selling covered calls requires a certain mentality. Here are a few things to consider:

• The stocks you own are objects that exist to make money for you.
• Selling covered calls are an additional income source.
• Having a stock called from you is a winning proposition because it means you just made a lot of money (assuming you followed the guidelines provided here). Notice in the example provided in the previous section that the gain was 20%.
• Having the option expire out-of-the money means you made money from selling the option. It gives you the opportunity to continue getting paid dividends from the stock. It gives you the opportunity to sell more covered calls.
• You can always just buy the stock back to continue receiving dividends.

Steps to Sell Covered Calls

Remember the three things that the call buyer must get right to profit from his call option (direction, magnitude, and time).

You want to position yourself on the other side to minimize his chances.

You only need to get one factor right to keep his money.

He's already decided the direction of the market--up--because he's buying a call option.

You just need to sell a call that is far enough away from the stock's current price, and only give the buyer a short window of opportunity. This puts delta, theta, and vega on your side.

1. Use Yahoo! Finance to see which stocks in your portfolio trade options.

   Only initiate a position on a stock if the call option's strike price is above your cost basis. This will prevent locking in a loss if the stock is called from you.

2. Look through the list of call options with an expiration between 1 to 3 months away that are out-of-the money and offer a reasonable premium.

   Why do we choose expiration dates 1 to 3 months away?

   Options lose more value per day as the expiration approaches. It also gives the stock less time to move.

   Why choose an out-of-the-money option?

   Make the call buyer have to make one more decision to reduce his opportunity of being right. It requires the stock to make a big move which reduces the probability of the option expiring in-the-money.

   What is a reasonable premium?

   Something that will satisfy you after you take commissions into account.

   If you can only sell 1 contract and the Bid Price is $0.10 you'll only receive $10. If your commission is $7 you'll only net $3. Is that worth the effort?

   You'll either need to sell more contracts (assuming you own more that 100 shares), move to a closer strike price, consider a longer expiration date, or move to a different stock.

   Some illiquid stocks or stocks with low volatilities will not make good covered call candidates.

3. Find a free online options calculator to tell you what the expected return is for the transaction. The calculator will also determine the probability that the option will expire worthless or not using data you provide. Remember that historical volatility may not be indicative of future price movements, so use the probability information wisely.

   This link takes you to a free online covered call calculators (opens in a new window):

   Volatility Trading Calculator

4. Enter the order to sell the call contract you select through your broker. Each contract is for 100-shares so if you own 300-shares you can sell up to 3 call contracts.

5. Monitor your position.

What do you do with your covered call?

• You can do nothing.

  An out-of-the-money option expires worthless. You can enter into another covered call after expiration.

  By the way, do not enter into a new contract on the the last trading day prior to expiration (3rd Friday of the month) because expiration is actually the day after (Saturday). Entering into a new trade, even if the expiring option is out-of-the-money, results in two open options for that brief period.

  An in-the-money option will be exercised. The stock will be removed from your account and the account will be credited with the money from the stock purchase. Your stock broker does this for you.

  Remember, this is a good thing! Because you placed the strike price above your cost basis you made money on this transaction.

  If the stock still looks good you can buy it back.

• You can roll the call up.

  If the stock's price is approaching the strike price or is above the strike price and you really don't want to let it get called away you can buy back the option and then sell another option at a higher strike price.

  Doing this will eat away the credit you pocketed earlier.

  You are not limited to the same expiration date. You can simultaneously roll up to a higher strike price AND a farther expiration date which may allow you to maintain your credit.

• You can close out the position.

  You can buy the call option back and continue holding the stock if the stock's price is approaching the strike price and you don't want to sell the stock.

  Or you can completely close out the position by buying back the call and selling the stock. You should do this whenever you have a sell signal on your stock (like dropping below its 200-day moving average).

  Do not sell the stock without buying back the call option because that leaves you with a naked call and unlimited risk.

• You can roll the covered call down.

  If the stock price has fallen you can either let the covered call expire, or you can buy it back (it will be cheaper than you sold it) and sell an option with a lower strike price.

  I do not recommend rolling down if it results in the new strike price being below your break-even point (cost basis minus credit from the covered call) because this will lock in a loss.

  You are not limited to the same expiration date. You can simultaneously roll down to a lower strike price AND a farther expiration date which may allow you to maintain your credit.

I mentioned earlier that the covered call strategy is considered a conservative and safe strategy because the long stock combined with short call option limits the upside risk.

The misconception is that limited risk means small risk.

It's true the risk is limited, but you need to remember that it's limited to ALL the money you put at risk when buying the stock.

If the stock price falls, you still sustain a significant loss!

If the stock price falls to zero you will lose all your money!

Don't let that happen.

You can close out the covered call and sell the stock if its price falls to your break even point.

You can also use a hedge on your portfolio. I have developed a very simple, effective, and low cost hedging strategy using put options. I describe the strategy in detail in my eBook. CLICK HERE to learn more about this inexpensive but high value eBook (link will open in a new window).

Covered Call Complaints

Here are a few common complaints against Covered Calls

• Selling covered calls limits your profits.

  You can always buy the stock back and continue to participate in the stock's upward move.

  The option you sell has a short time period to expiration. The dividend stocks you own probably have a lower volatility than other stocks. The probability that your stock will sky rocket uncontrollably in price during that short period is unlikely.

  Continue to sell covered calls with higher out-of-the-money strike prices.

• You incur capital gains taxes when the stock is called away.

  True. I do not like paying taxes, but I will incur capital gains taxes if it means profiting from the transaction. This is a cost of doing business.

• You lose out on dividends once the stock is called away.

  True. You can buy back the stock that continues to interest you. The additional money from your profit means you can buy back the same number of shares, or may even allow you to buy back more shares.

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