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Boost Your “Yield” By Writing Covered Calls

12 January 2010 10 Comments

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.

10 Comments »

  • Randy said:

    Hi Kevin,

    I don't have much insight to options, but this post seems pretty interesting to me. I was also wondering,

    1) How much would you lose if company X does go over the strike price?

    2) What happens if company X goes below $50?

  • 20smoney (author) said:

    If company X goes over the strike price, you are forced to sell the stock. So you don't lose anything, but you lose potential additional upside profit. Your only risk in writing covered calls is that you limit your upside.

    If company X goes below $50, nothing happens, your options expire worthless, you keep the premium and you keep the stock.

  • Jeff said:

    I commend your use of covered calls — they are my sole method of investing and it is a very good, conservative strategy.
    It would be helpful if you would include the details of your trades to further educate your readers. For example, I always find it worthwhile to calculate the potential return if the stock price is unchanged at expiration as well as the return if the stock is exercised at expiration. For an example, view the most recent post on my Covered Calls Advisor blog:
    http://coveredcallsadvisor.blogspot.com/

    Regards,
    Jeff

  • 20smoney (author) said:

    Thanks for the comment. I will plan on providing an update of the trades… I've also added a third covered call on my FXP position which has the best return out of all of them… update should be posted within the week or so.

  • Brad said:

    Hi kevin, I like your blog alot. I have two questions. 1. How did you come up with the 1.4% return on your position and a 16.8% annualized return? I dont know how you came up with both those mathwise. thanks

  • 20smoney (author) said:

    I don't either. I made a mistake. It should be 8.4% — basically look at 1.4% over 2 months — if you take that over 12 months, you get an 8.4% in a very basic way of looking at it.

    16.8 is completely false and I've fixed it thanks for the notice.

  • Sean said:

    How do you make a covered call?

  • 20smoney (author) said:

    Sean: a covered call is when you own the actual shares of a company, then you would "write" or "sell" a call option on that same stock. You can talk to your broker about what you'd like to do and he/she should be able to help. You would want to "sell to open" a call position for this strategy. As such, closing it out would be a "buy to close".

    hope that helps. if not, there are a bunch of Options 101 type articles on the internet, just do a little searching. Thanks.

  • ratings said:

    I haven't understand how you profit from the method you mentioned,I'm just a newbie in stock trading

  • blogc2011 said:

    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 research papers for sale http://www.best-term-paper.biz/.