subject: Squeezing Additional Income From Your Stocks by:Kerry W. Given, Ph.D. [print this page] Many people think of options trading as very risky and suitable only for the high rollers. This article briefly surveys how options can be used in conservative financial portfolios to boost the income from your stocks.
For the purposes of this article, lets assume we have a stock portfolio of conservative stocks, e.g., IBM, GE, etc. We may be realizing moderate price appreciation of the order of 5% annually plus dividend yields of 3%, for total portfolio growth of 8 to 10% annually. One easy way to boost our annual gains without increasing our downside risk is to sell call options against our stock holdings. This is known as a Covered Call.
A Covered Call is created by selling the appropriate number of call options against stock in our portfolio. Lets assume we own 500 shares of shares of IBM and IBM closed at $104.69 on May 28, 2009. We are concerned the stock may trade sideways or only slightly upward for the next few weeks. We could sell 5 contracts of the June $105 call options for $2.35, or $235 per contract. This brings $1,175 into our account. If IBM closes at any price less than $105 on June 19, the calls we sold expire worthless and we keep the $1,175 we received and this represents a 2.2% return on our investment in IBM. However, if IBM rallies to any price above $105 by June 19, our stock will be called away, i.e., whoever holds those calls that we sold, will exercise them to buy our 500 shares of stock for $105/share. In this case, our account balance will stand at $105,000 plus the $1,175 we received for the calls or $106,175. This represents a gain of 2.5% for about three weeks.
There are always trade-offs for any investment strategy and the covered call is no exception. The downside of the covered call strategy, illustrated by this example, is that we gave up any stock price appreciation beyond $105. In return for surrendering that upside potential, we were paid $1,175, or 2.2%. If we are using the covered call strategy with conservative stocks like IBM, it is unlikely that we will see big moves in the stock price very often. Most months will see our call options expire worthless and we will take in additional cash as the stock price moves sideways or slightly upward. Adding one to two per cent income per month to our conservative stock portfolio adds up over the year.
Some traders use the covered call to increase the income from a conservative stock portfolio when the market seems a little slow. Others select and buy stocks with the express purpose of selling calls against those positions. In either case, the position should have a stop loss contingency order placed with the broker to protect the downside. The covered call strategy can be expected to yield about 2-3% per month. Of course, every trade will not be a winner, so it would be foolish to project annualized returns of 24-36%, but one can use this strategy to boost the income from a conservative stock portfolio.
One forewarning is in order when using covered calls with blue chip, dividend-paying stocks. If the call options you sold are in-the-money, or ITM, as you approach expiration, the calls are rarely exercised early if there is more than $0.05 to $0.10 of time value left in the option premium. However, if the stock is about to go ex-dividend, the call may be exercised early to take advantage of receiving the dividend. The dividend paid to the stockholder may outweigh the time value lost upon exercise.
The Covered Call is a conservative strategy for boosting the income of a blue chip stock portfolio. However, the disadvantage of this strategy is the sacrifice of the gains above the price of the call option sold. Selling calls against highly volatile stocks would be a much different strategy than our example with IBM. A Google (GOOG) covered call would be much more aggressive; when GOOG is quiet and trading within a range, we would make a nice return, but when GOOG makes one of its $100 runs within a few weeks, as it did recently, we would be caught with a $10 or $20 return instead of the $100 return. When covered calls are used in conservative stock portfolios, boosted returns of an additional 5% to 10% per year are reasonable expectations, and this can be done without increasing the downside risk.
About the author
Kerry W. Given, Ph.D., aka Dr. Duke, has over twenty years of experience investing in the stock market and over seven years experience trading equity and index options. He has taken many classes on investing and trading through the years and has discovered first hand how difficult it can be to separate the financial facts from the marketing hype, myths, and get rich quick schemes. He can be reached at: http://www.ParkwoodCapitalLLC.com
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