Covered Call Writing: Combining Stocks and Options to Create a Monthly Cash Flow
This is a strategy for average retail investors. If you have never heard of covered call writing, shut the TV, put the kids to bed and enjoy the ride. We all have a basic idea as to how to buy and sell stocks. Many investors are scared to death to trade equities after the recession of 2008 decimated the stock market. Stock options are considered way too complicated and risky by most retail investors. So how are we going to convince hard-working blue collar investors to use a plan that incorporates both stocks and options? The answer is through education, motivation and due-diligence. The fact that you are reading this article demonstrates that you have an interest in putting your money to work for you so you won’t have to go to work yourself.
I was first attracted to this methodology when I was reading an article on self-directed IRAs. The article stated that you could sell options on stocks you owned in a self-directed IRA. Options in an IRA, I thought? How could that be? Why would the government allow us to trade options in our retirement accounts? The answer is simple. This is not a risky strategy. It is a low-risk (not a no-risk) system of combining stocks and options used to generate a monthly cash flow. Here’s how it works:
The first part is easy. You select a stock that is fundamentally sound. That means that the corporation is producing stellar earnings and revenues. We then make sure that the price chart is technically sound. We must learn how to read a stock chart. This will NOT be a challenging task. Finally, we add a few common sense principles like proper diversification (don’t buy five stocks, all computer hardware securities), avoiding volatile risky stocks and a few others and part one is accomplished. All this information can be accessed for FREE on the web.
The second leg of this program is a little tricky but NOT rocket science. We sell an option on the stock we own. This means that we sell to the option buyer (holder) the right, but not the obligation, to purchase our shares from us at a price that WE determine, by a date that WE determine and in return we will receive a cash premium that the market determines. That cash is generated into our account immediately for us to do whatever we want with it. This is all accomplished with the click of our mouse on our computers, like buying a book on Amazon.com. We can then head to the mall with this cash but I don’t recommend it. Later in this article I will discuss the power of compounding.
Let’s make this all come alive with an example. We have $50k to invest. We allocate $10k each to 5 of the greatest performing stocks in the greatest performing industries. Each stock is in a different industry so we are properly diversified. One of these equities we will call Company XYZ and it is trading @ $33 per share. $10k will allow us to buy 300 shares. Our investment in this stock is therefore $9900 (300 x $33). We now sell a call option and decide on a sale (strike) price of $35 good for one month (options expire on the third Friday of the next month). Since each options contract consists of 100 shares, we sell 3 contracts. Our obligation is to allow the option holder to buy our shares for $35 at any time over the next month. In return for undertaking this obligation we receive a premium of $1 per share or $100 per contract. This is a reasonable return for such a hypothetical. Now sit back and enjoy the math:
Our initial return is $300 ($1 x 300 shares)
This is a 3%, 1-month return ($300/$9900) or 36% annualized
If the option is exercised (sold for $35) we make an additional $2 per share or $3 total
In this scenario our 1-month return is $900 ($3 x 300)
This is a 9.1%, 1-month return or 109% annualized
Let’s look at some of the scenarios:
- The stock goes up more that $2…we earn 9.1%
- The stock goes up but less than $2…we earn between 3% and 9%
- The stock stays the same @ $33…we earn 3%
- The stock goes down but less than 3%…we earn between 0% and 3%
- The stock goes down more than 3%…we start to lose money but are prepared to act with our exit strategy arsenal
This sounds too good to be true…are there any disadvantages? The answer is yes, the stock can go down in price despite all of our fundamental, technical and common sense analysis. If it depreciates more than the premium generated, we start to lose money. This is where our exit strategy plans kick in and perhaps this will be a topic for a future article.
One last thing… I mentioned compounding earlier in this article. Unlike most other strategies the cash generated form covered call writing is in our accounts in seconds. We can re-invest this income, purchase more stocks and immediately sell options on the newly-acquired securities thereby compounding our money in MINUTES! Using the Rule of 72, if we achieve a 2% monthly return, a $100k investment will become $1.6M in 12 years. There is no one strategy that is right for everyone but this may be the one for you. Now wake up the kids and put on the TV. Hope you enjoyed the ride.
Alan Ellman loves options trading so much he has written three top selling books on the topic of selling covered calls alone. He is a recently retired dentist, a personal trainer, successful real estate investor, but he is known mostly for his profound stock option strategies.
Alan used the power of self-education to accomplish my mission of becoming an accomplished stock market investor. He used the same blueprint that he adapted to become a licensed General Dentist, a Certified Personal Trainer, and a Licensed Real Estate Agent. Year after year, his portfolio generated higher returns than those of the average Stock Market. When he started selling options, those returns increased exponentially. Be sure to check out Alan’s NEW book “Selling Cash-Secured Puts.”