The Beauty of Covered Calls

covered-callMy goal and my promise to Peak Income readers is to secure for them a high and stable income stream, no matter their situation: in retirement, close to retirement, or just even thinking about retirement.

I want paychecks to hit brokerage accounts every month, with consistency and low risk and without worry. No wonder I’m often called a tightwad.

But, as much as the next guy, I also like to snag capital gains when I see a good opportunity.

And, right now, I’m doing just that by looking at a conservative, overseas private income fund that juices its yield…by writing covered calls.

Let me start here: A call option is the right – but not the obligation – to buy a stock at a certain price by a certain time.

Here’s an example.

A May 19, 2017, call option on Apple (Nasdaq: AAPL) with a strike price of $155 would give the buyer the right to purchase 100 shares of Apple at $155 per share on or before May 19.

If Apple closes at $154 per share, the option expires worthless. No one would voluntarily buy a stock at $155 if they could buy it at $154 instead.

But if Apple goes above $155, that option is “in the money” and suddenly has value. If Apple goes to $160 before May 19, the buyer can execute at $155 and pocket a quick, $5-per-share profit.

So you see how this works. Call buyers pay a premium to speculate on stocks that they expect to go higher.

But what about the call seller that takes the other side of the trade?

Their motivation is much different.

They collect the premium from the buyer in the hope that the option expires worthless and they get to keep the full value of the premium. Of course, it doesn’t always work that way.

In our example that saw Apple rise to $160, the option seller would have to buy Apple at the market price of $160 and then turn around and sell it to option buyer for $155 per share, taking a $5-per-share loss.

That’s not a lot of fun.

But it brings me to covered-call writing, the strategy used by a handful of funds in the Peak Income model portfolio. We don’t have a lot of them, but the ones we hold have been good to us.

When you write a covered call, you sell an option on a stock you already own. So, extending our Apple example, if you owned 100 shares of Apple, you could sell a call option against it and pocket the premium.

If the share price doesn’t move above the option’s strike price before expiration, you pocket the premium and whatever modest capital appreciation, along with any dividends paid. That’s your best-case scenario.

In your worst-case scenario, Apple runs higher and your shares are called away from you. But, as far as worst-case scenarios go, it’s really not all that bad.

You still sell your Apple shares at a profit, and you still have the cash you collected when you originally sold the option. Your upside was capped, but no harm was done.

And that’s the beauty of a covered-call strategy. It’s a low-risk way to milk a little extra income out of a stock you own. And we’re not even buying single stocks, like Apple, in Peak Income. We’re buying a fund.


Note: Charles Sizemore is the author of this article. He is a contributor to Economy & Markets Daily.

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Category: Covered Call Writing

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In Economy & Markets Daily, the Dent Research team, featuring editors Harry Dent and Rodney Johnson use the power of demographic trends and consumer spending patterns to accurately identify economic booms and busts well ahead of the mainstream. Harry & Rodney believe demography is destiny. It is the future that has already been written. You just need to know how to read it.