Many friends ask me questions about options trading.
Often, I answer with a question: “Are you selling covered calls against long shares you own?”
Most of them say no. Others say they really don’t understand that strategy at all.
So, today I want to lay out all the details, with actual numbers, to help those who may be confused about this incredibly powerful strategy.
As a refresher (I’ve written many times about covered calls in The Rich Investor): for every 100 shares of a stock you own, you can sell one call option contract against those shares.
This accomplishes three things:
- It creates instant cash flow, as you receive the upfront premium payment from the option buyer.
- It helps create a downside buffer against temporary dips in the stock.
- It helps set an automatic upside profit target. If the stock rallies above a certain level, you can sell your shares and lock in a pre-determined profit point.
How Does It Work?
Let’s say you currently hold 1,000 shares of Walmart (NYSE: WMT) that have been sitting in your account for several years.
Your buy-in price was $60 in 2012.
WMT stock now sits at $98.30.
Here’s a current chart.
That means you’re sitting on a gain of $38.30 ($38,300 profit) and a return-on-investment (ROI) of 63.8%.
Now Let’s Juice Those Returns
If you’ve been reading my articles in The Rich Investor, you know I’m a big fan of selling options contracts and collecting the upfront income.
One of the best ways to do this is to sell covered calls against the shares of stock you already own. No sense in leaving money on the table, right?
While your goal is to hang onto the shares as long as possible to gain more capital appreciation, it never hurts to bring in a little extra cash. But, how much cash?
Well, let’s look at the current option chain below.
I’ve circled the September 2019 $110 call options as the hypothetical play.
This is an out-of-the-money (OTM) option, meaning its strike price is set higher than the current stock price. At the moment, the $110 strike is roughly $12 above WMT’s current stock price of $98.30.
Since you own 1,000 shares, you could sell 10 of the September 2019 $110 call options for $1.37 per contract (splitting the bid and ask) and immediately get $1,370 from the sale ($100 option multiplier x 10 contracts).
If WMT moves above $110 by September, you will relinquish your shares and book a very nice gain on your long-term hold.
If WMT remains below $110 by September, you retain your shares AND the option premium, and can sell another 10 contracts to produce even more current income.
Wash, rinse, repeat.
In the case of a blip lower in the stock price, the sale of the call option covers you for a small move, specifically, $1.37 per share lower.
Let’s Add Up the Numbers
Suppose WMT finishes above $110 by September. What happens?
Your shares will be called away by the option buyer and you’ll record the sale at $110.
You’ll net a final $50 per share capital gain ($50,000) and a ROI of 83.3%.
In addition to that large capital gain, don’t forget about the $1,370 of upfront option premium you collected, and the three dividend payments you’re entitled to between now and September.
With WMT paying out $0.53 per share in dividends, you’ll collect another $1,590 by expiration.
All told, that’s a nice payday!
But what if you’re concerned about missing out on even more upside gains?
That’s probably the only “drawback” to the strategy, but there are things you can do to minimize that.
For one, you can use a higher strike price, like the $115 or $120 strikes. By doing so, you lessen the chance of WMT moving that far, but you will also receive less upfront income. That’s the trade-off.
Or, you can choose a longer expiration date. The more time until expiration, the higher the option prices. This means you get more money when selling the calls.
And speaking of chances, you can always consult a probability calculator to give you an idea of how likely it is that WMT will hit $110 by September.
Looking at the results above, we see that WMT has roughly a 27% chance of finishing above $110 by September.
What if it doesn’t finish above $110?
Well, as I said earlier, the option will expire and you’ll keep your shares. This will allow you to sell another 10 option contracts and hopefully collect another $1,370.
You could conceivably continue this process over and over and collect upfront cash for years on end. As long as WMT doesn’t close above the strike price, you’re good to go.
Selling covered calls is a viable way to pad your trading account. Don’t let that cash slip away!
Until next time…
P.S. My friend and colleague, Adam O’Dell, enjoys educating you about options and investing almost as much as I do. And on Monday, March 11, 2019, he’ll be opening up a special offer. Be sure to tune into The Rich Investor this coming Monday to hear more…
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