Disclaimer: We here at skillbuilderdad.com are neither financial advisors nor professionals. This article expresses the opinions from the personnel at skillbuilderdad.com, and is for inspirational and educational purposes only. The investment decisions you choose to make are 100% YOUR responsibility. Investing of any kind involves risk, and options trading can involve BIG risk with BIG losses. It is recommend that you consult a financial advisor before making any trades.
Verizon Communications Inc. is trading around $55/share, and is paying a dividend of 4.5% (at the time of this writing). This means that if you own 100 shares ($5,500) then you will receive a dividend payment of $247.50 every year. Since the dividends are paid out quarterly, you will receive around $62 every 3-months. Breaking it down even further, the monthly amount would be around $21/month. I’m not sure about you, but this doesn’t even come close to covering my phone bill.
What if there was a way to collect more than your dividend, on a stock you already own? Well I am here to tell you: THERE IS! How, you might ask? By writing covered calls! Don’t worry, if that last sentence sounded greek to you, then by the end of this article, you will completely understand. If it still sounds greek, then go back to Options Part 1 for a quick refresher.
Below is an option chain of Verizon, expiring about 1-month away (at the time of this writing), using the Fidelity platform. Let’s take a look at the left two columns, called the “CALL” side. Within these 2 columns, we have the leftmost column, which is the “BID”, and right next to it is the “ASK”. Since we will be selling a call (also known in financial jargon as “writing a call”), we are interest in the leftmost “BID” column.
Before going any further, we must look back at the title of this article, and in parenthesis it states “Writing Covered Calls”. We know we want to sell (write) a call option, but what does “COVERED” mean? It simply means that you own the stock. More specifically, you own 100 shares of the stock for each call option you plan to sell.
Confused yet? GOOD. Let’s think through what “writing a covered call” is all about:
When writing one (1) covered call, you are selling the rights to some stranger to be able to “call-away” 100 shares of the stock you own, at a given price. Let’s say for example, you own 100 shares of VZ, trading at $55/share, and you sell a call to stranger Luigi using the option chain above, for a strike price of 56.00. Since Luigi now owns this contract, he has the right to buy your 100 shares at $56/share. Why would Luigi do such a thing? Well, let’s say tomorrow VZ gets some analyst upgrade and skyrockets to $60/share. Since Luigi owns the contract, he can now exercise it and “call-away” your 100 shares, purchasing them from you for only $56/share. He can then sell the shares on the market for $60/share, collecting a nice profit of $4/share ($400).
Yea, but what about my money? Why would I want to lose out and let Luigi collect all the coin?
In the example above, you sold one (1) call option*, and Luigi was the buyer. You probably met in the middle somewhere between the BID price of 0.77 and ASK price of 0.96, at let’s say 0.86. As the owner of 100 shares of VZ, you also collected $86 to SELL one (1) option contract. As for Luigi, he had to PAY $86 for the contract, so his actual profit is $400 minus $86 (=$314). If you purchased your 100 shares of VZ at $55/share and they were called away at $56/share, you made $1/share ($100). Your total profit in this scenario is $100 plus $86 (=$186). It’s a WIN/WIN scenario for both you and Luigi.
*Trading tip: Use the SELL to OPEN option when making the trade, and set a limit SELL order at a value somewhere between the BID/ASK price, in order to get the best price for your contract. If the trade does not execute within a few minutes, drop your limit by one point (ex: from .87 to .86) each time, until the trade executes. For this strategy, you will not necessarily need to close-out the trade (BUY to CLOSE), as you are waiting for either the option to expire worthless, or for Luigi to exercise his option contract.
Okay, I get it. If the stock goes up, Luigi has opportunity to profit. What if the stock stays the same, or goes down?
If the stock stayed the same and/or stayed below the strike price of $56/share, then Luigi would not be able to exercise his option (he cannot exercise unless the stock goes above his strike price). You get to keep your 100 shares and the $86 that you sold the contract for. The contract expires worthless in about 30 days, and Luigi loses out on his $86 of coin.
The goal for this strategy is to NOT have your shares get “called away”. However, if they do get called away, then you still profit. If you can consistently collect $86/month on your $5500 investment, then this would be equivalent to collecting a 19% dividend ($86 x 12 months, all divided by $5500, then multiplied by 100%). If you manage to keep your shares for the entire 12-months, then you still get to collect your 4.5% dividend, for a total return of 23.5% annual return on investment. Not bad, right?!
In Conclusion
Remember that when you sell one (1) call option, you need to own 100 shares of the stock in order for it to be considered “covered”. If you sell two (2) call options, you will need to first own 200 shares, and so-on. If you do not own the shares before making the trade, this would be considered “writing a NAKED call”, which is a dangerous strategy that I do not recommend.
If you happen to own 100+ shares of a stock you enjoy holding onto for long periods of time, this may be a good strategy for you. Just MAKE SURE you own 100 shares for each call option contract you sell, and enjoy collecting better dividends!
Disclaimer: We here at skillbuilderdad.com are neither financial advisors nor professionals. This article expresses the opinions from the personnel at skillbuilderdad.com, and is for inspirational and educational purposes only. The investment decisions you choose to make are 100% YOUR responsibility. Investing of any kind involves risk, and options trading can involve BIG risk with BIG losses. It is recommend that you consult a financial advisor before making any trades.