Boost Your “Yield” By Writing Covered Calls
I’ve recently written some covered calls on two of my positions:
- Philip Morris Int’l (PM)
- Market Vector Gold Miners ETF (GDX)
I’ve done this because I believe the short term upside is limited (looking out to January or February 2010). By writing the covered calls, I become obligated to sell my position should the price of the stock increase to the strike price of the calls (example below). If the price stays put or falls, I hang on to the stock and keep the premiums from selling the calls. The only risk is if the stocks go higher than the strike price in the short time period ahead. This is a risk that I’m willing to take.
Both positions above represent long term positions for me. I am a believer in the fundamentals of both positions. Since GDX does not offer a dividend, it is nice to get some cash flow from the position from selling the calls. PM does have a dividend, so I’m “boosting” the yield through writing calls on the position.
Let’s look at a basic example so that you understand the strategy clearly…
Let’s say company X has a stock that is selling for $50 and I currently own 100 shares of it. I love the company and want to hold the stock, but I’m not sure there is much upside left (it’s had a nice run recently) over the short term. I am going to sell the February calls with a strike price of $55 for a premium of $.70. I sell one contract (equals 100 shares) for $70 and am now obligated to sell my shares of X should the price rise from $50 to $55 by February (the expiration date).
The $70 I have collected is basically a 1.4% return on the position ($50 x 100 = $5000). But, the return is only over a 2 month time span, so annualized the return would be 8.4%. If company X were paying a dividend, I’d still be collecting this too.
As you can see, you can potentially get a very large return on your positions by combining a dividend yield and some covered calls. Now, if you keep writing calls on your positions, you will almost definitely eventually hit your strike price and be forced to sell your stock. It’s important to understand this.
Taking a look at the current market, it might be a good opportunity to sell some calls on your positions that have had a good run. If you hit the strike and have to sell the stock, maybe it’s not such a big deal since you’re just cashing in a big profit. If the stock corrects, you will outperform the stock due to the premium collected on the trade.
I will keep you up to date with how this strategy works out on my two positions: GDX & PM.