Selling Covered Calls
Editor and master trader Jeff Clark calls this idea "the single best income generating strategy ever created." It's known as "covered call writing," and Jeff's used it to make a fortune for himself over the years. To learn more about this low-risk way to earn more income from your investments, keep reading.
Interviewer: Jeff, could you explain how covered call writing can dramatically increase the amount of income you receive from your investments?
Jeff Clark: Sure. "Covered call writing," which is sometimes referred to as "selling covered calls," is my favorite strategy to generate investment income from a portfolio.
I had a client once who started out with 2,000 shares of a company called Siebel Systems. By using this strategy, we were able to generate an incredible half-million dollars in income in just a single year. The guy bought a vacation home in Tahoe with his earnings.
In a nutshell, the strategy involves buying a stock, and then selling someone else a contract that gives them the right to buy that stock from you at a predetermined time in the future. These types of contracts are called "options."
Interviewer: When putting this idea into context for folks in the past, you explained it in terms of buying and selling real estate. Can you go into that idea here?
Clark: Let's say you buy a piece of property for $200,000. You then turn around and sell someone the right to buy it from you anytime in the next three months for $210,000. For that right, you charge a fee of, say, 4%, or $8,000.
You pocket the $8,000 immediately. It's your money now. You are also obliged to sell the property for $210,000 if the buyer chooses to exercise his right.
This scenario has three possible outcomes...
First, the property goes up in value, and the buyer exercises his right to buy. In this case, you've pocketed the $8,000 premium, and you'll be selling the property for $210,000. Here, you'll have an $18,000 gain (9%) in three months, and you'll have to find another investment property to buy in order to continue the strategy.
Second, the property remains worth $200,000. In this case, you keep the $8,000 premium. Since the buyer won't be willing to pay $210,000 for a property that's only worth $200,000, you'll keep the property, too. You've made 4% over three months, and you can even sell the right to buy your property again, presumably for another $8,000!
Third, the property falls in value. In this case, the $8,000 premium you received helps to offset the loss on the property. The buyer walks away when the right expires, and you're also free to sell another right.
So if the investment goes up, then we sell it for a gain. If the investment stays the same, then we profit off of the premium. And if the investment drops in value, then the premium helps offset the loss.
Interviewer: Now how about a hypothetical example with a stock?
Clark: Let's say you buy shares of stock ABC at $20 per share. You think it's a great value at $20.
You can sell someone the right to buy your shares from you at $22 per share. You receive $1 per share for agreeing to sell your stock at a higher price. And the contract is good for three months.
If ABC rises to $23 in three months, you have to honor your agreement and sell your stock for $22 per share. You collect $2 in capital gains, and you keep the $1 per share you received for entering the contract. In this case, you make $3 per share on your purchase price of $20 per share. That's a return of 15% in three months, which is fantastic.
Interviewer: What happens if ABC does not rise in price? What if it trades sideways for the next three months?
Clark: You do nothing. You just keep that $1 per share you received for entering the contract. That payment – which is called a "premium" – is yours to keep, no matter what happens. That's a 5% return on your stock position. In the case of ABC trading sideways over the next three months, you'd keep the premium and possibly look to do the same transaction again.
Interviewer: Great. You make money if ABC goes up, and you make money if ABC trades sideways. What if ABC goes down?
Clark: If ABC goes down, the $1 you received for entering the contract cushions your loss. And since you think ABC is a great value, you'd probably hold onto it and look to sell more calls against your position.
Interviewer: It sounds like a terrific strategy. Are there any pitfalls?
Clark: There are two major pitfalls...
First of all, if the investment collapses, the small premium you received by selling the option won't do much to alleviate the loss on your "safe" money. If a stock drops a little, say 10%-20%, you can make up for some of the loss by selling the premium a few times. But you will not be safe from a 50% loss with this strategy.
With this strategy, you want to look for low-risk stocks where the options can generate 15%-20% annual returns.
The other pitfall to covered call writing is that you sell off your potential for enormous gains.
Take our real estate example. We are obligated to sell the property for $210,000. That's a good gain, especially considering the extra $8,000 premium. But if the property jumps to $300,000, then we'll be kicking ourselves for selling at such a cheap price.
But here's the thing... The purpose of covered call writing is to generate income, not capital gains. It's the difference between buying a bond and buying a stock. Stock buyers look for capital gains. Income is secondary. Bond buyers want the income, and any gains are a bonus. Folks who write covered calls are similar to bond buyers.
If you like the prospects of a stock and believe it could easily double or triple, then don't sell options against it. You'd cap your profit potential and guarantee that you'll be out of the trade before it goes higher.
To put it another way, you should only sell calls against stocks that you wouldn't mind selling at the agreed upon price.
Interviewer: This is where many folks go wrong with a covered call strategy, right?
Although it involves the use of options, covered call writing is really quite safe and simple. But many people think this is a risky strategy... because most people do it wrong.
They buy high-risk stocks because the option premiums are expensive and generate the largest current return. But then, the stocks collapse, and investors are stuck with losses.
The secret here is to focus on not losing money by buying low-risk value stocks and then selling the calls. If you do that, then the returns come quite easily. That's it.
For my clients in the past, I keep the risk very low by picking the right stocks. By focusing on conservative, value-oriented stocks we eliminate a lot of the volatility that can wipe out several months' worth of gains overnight. We also avoid the temptation to chase the highest-yielding covered call positions, as those tend to be the trades that are most likely to blow-up.
Understand that this is different than the way in which most people approach covered call writing. Most people start by looking for options that carry the fattest premium and then find a way to justify owning the stock. That's why most people have a tough time generating consistent income through covered call writing.
Interviewer: Thanks for talking with us today.
Clark: Thank you.