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When Apple's (AAPL) swelling pile of cash was causing investor frustration earlier this year, Tim Cook, the relatively new CEO, announced a quarterly cash dividend of $2.50. The $10 annual payout currently gives Apple a 1.8% yield. With the potentially higher tax rates on dividends in 2013, many companies are paying out a special dividend to help investors fight the tax man. Some investors are clamoring for a hefty payout from Apple, with such a large cash pile still in existence.

This article isn't about annual dividends, nor is it about whether or not Apple will pay out a special dividend before the end of the year. But how can Apple be a substantial income stock without discussing yields and dividends? Simple, by selling covered calls to generate your own income from Apple.

This strategy may not be for everyone. In fact, it's likely for a minority of investors, rather than a majority. But looking back to 2004, three years after Apple introduced the iPod that revolutionized the music device industry, Apple traded for a measly $13.00. A thousand shares would've only cost $13,000, and would've been worth over $700,000 at its peak, when Apple traded at a 52-week high of $705 earlier this year.

(click to enlarge)

Source: Stockcharts.com

Shoulda,' Woulda,' Coulda.' But heck, even in 2009, shares of Apple had fallen over 50%, down to just under-$100 per share. Five hundred shares back then would've cost $50,000, a price tag still outside of some investors' budget, assuming they want to maintain a reasonable risk-allocated portfolio, but you could always buy less too. Any way you slice it, Apple is viewed by many as the "missed train," with 100 shares currently going for $57,500, which is just too steep for many retail investors.

But what if you were on that train? What if you did buy 1000 shares of Apple in 2004, or 500 in 2009 and saw the revolution Apple was making with the iPod, iPad and iPhone? Then there is a way you can get your share of income from Apple, without waiting for its quarterly dividend payouts and without selling your shares. By simply selling covered calls, you can generate a great return from your position in Apple.

Below is a chart illustrating an example of how you could use covered calls if your position size was 500 shares. For the 1000 share position, you could double the call options used, or add a few where you see fit:

Covered Calls We're Selling

Premium Received

Difference Between Strike Price & Current Price

Days Until Expiration

December 28 Weekly 600

$8.00

$25

24

December 28 Weekly 600

$8.00

$25

24

December 28 Weekly 610

$5.60

$35

24

January 625

$8.50

$50

45

January 650

$4.60

$75

45

Total

$3,470

Average

$694

$42

Before we go any further, let's discuss selling covered calls in a little more depth for those considering doing this to their position, or just learning about options and looking for an example. First, if you're not familiar with options or comfortable using them, you should do some practice trading in a simulated account, before putting real money on the line.

When you are using your actual account and choosing the strike prices, you have to be willing to part with your shares. If you're not okay with doing that then this isn't the strategy for you. A more conservative approach would be to choose far out-of-the-money strike prices, to lower the likelihood of assignment, but it will also lower your income from the collected premium as well. You also may not want to part with the shares due to tax implications -- or perhaps you do, because of the impending "Fiscal Cliff," in which case you would likely want to choose slightly out-of-the-money strike prices. Remember, you can always repurchase the shares again at a later date.

When you are shorting options to collect premium, it's important to understand how time decay works -- both for and against your position. While it may be more tempting to sell a call option way out in March or June of 2013, you run a lot more risk of the underlying stock, in this case Apple, finishing above the strike price. You'll collect more premium doing this, but sacrifice future capital gains, and time decay will not be working in your favor.

Time decay in options happens exponentially, meaning the decay is not linear (a straight line). The more time until expiration, the slower the time premium in an option will decay. During the last 30-45 days of an options lifetime, time decay begins to rapidly increase. This is especially true with options that are at-the-money, or slightly in- or out-of-the-money. For example, the December $500 strike call in Apple will have very little time premium left to begin with, as it is mainly made up of all intrinsic value, thus it will have little time decay affects.

To take advantage of this phenomenon, it would be most beneficial to sell options that have a life span of only 30-45 days. We do this to collect a relatively juicy premium, knowing that time decay will soon start eating away at a faster and faster rate everyday. When being short the covered call, this is exactly what we want.

Below is a graph illustrating the time decay effect on options, where you can see the slow descent, until the last 30-45 days when time decay begins to accelerate rapidly:

(click to enlarge)

Source: OptionAlpha.com

So going back to the original chart above, we have an average strike difference of $42. What does this mean exactly? It means that if Apple closes above $650 on January 18, that on average, your whole position will be called away with a $42 gain per share, relative to Tuesday's closing price of $575. That's not including the capital gains you have thus far in Apple, or the premium you received from selling the covered calls to begin with.

Here are a few examples, for both the 1000 share and 500 share positions. Below are several different outcomes, with explanations for each.

Apple closes at $660 on January expiration and above $610 on December 28th:

1000 shares relative to Apple's current $575 trading price, sold for an average gain of $42 per share, for a gain of $42,000. The premium collected from selling the covered calls is $6,940, which is yours to keep. By using the original example of a $13 cost basis, the total gain is $613,940, including both the capital gains and premium collected.

1000 shares bought at $13, in 2004.

400 shares called away at $600 via the 4 short December 28 weekly 600 calls
($600 - $13 = $587 x 400 = $234,000 + $3,200 (collected premium) = $237,200)

200 shares called away at $610 via the 2 short December 28 weekly 610 calls
($610 - $13 = 597 x 200 = $119,400 + $1,120 (collected premium) = $120,520)

200 shares called away at $625 via the 2 short January 625 calls
($625 - $13 = 612 x 200 = $122,400 + $1,700 (collected premium) = $124,100)

200 shares called away at $650 via the 2 short January 650 calls
($650 - $13 = $637 x 200 = $127,400 + $920 (premium collected) = $128,320)

Now, 500 shares relative to Tuesday's $575 closing price, sold for an average gain of $42 per share, for a gain of $21,000. The premium collected from selling the covered calls is $3,470, which is yours to keep. By using the original example of a $100 cost basis, the total gain is $261,970, including both the capital gains and premium collected.

500 shares bought at $100, in 2009.

200 shares called away at $600 via the 2 short December 28 weekly 600 calls
($600 - $100 = $500 x 200 = $100,000 + $1,600 (collected premium) = $101,600)

100 shares called away at $610 via the 1 short December 28 weekly 610 call
($610 - $100 = 510 x 100 = $51,000 + $560 (collected premium) = $51,560)

100 shares called away at $625 via the 1 short January 625 call
($625 - $100 = 525 x 100 = $52,500 + $850 (collected premium) = $53,350)

100 shares called away at $650 via the 1 short January 650 call
($650 - $100 = $550 x 100 = $55,000 + $460 (premium collected) = $55,460)

Apple closes at $620 on December 28 but trades sideways for the first three weeks of January and closes at $610 on January expiration.

Now the situation is a little different but should help illustrate how covered calls work. Instead of all 1000 shares being called way from us at a huge gain, we only have 600 shares called away. The 600 shares are called away with an average gain of $28.33, relative to the $575 closing price on Tuesday. A deeper look below:

1000 shares bought for $13 back in 2004.

400 shares called away at $600 via the 4 short December 28 weekly 600 calls
($600 - $13 = $587 x 400 = $234,000 + $3,200 (collected premium) = $237,200)

200 shares called away at $610 via the 2 short December 28 weekly 610 calls
($610 - $13 = 597 x 200 = $119,400 + $1,120 (collected premium) = $120,520)

2 January 625 calls expire worthless, premium is yours to keep

2 January 650 calls expire worthless, premium is yours to keep

By selling 600 of the 1000 share position, we realize a gain of $364,660, including the premium collected. The other 400 shares are still in our portfolio and we can still write covered calls against them. We can buy back the 600 shares we sold any time we want and continue to write covered calls against our full position.

500 shares bought for $100 back in 2009.

200 shares called away at $600 via the 2 short December 28 weekly 600 calls
($600 - $100 = $500 x 200 = $100,000 + $1,600 (collected premium) = $101,600)

100 shares called away at $610 via the 1 short December 28 weekly 610 call
($610 - $100 = 510 x 100 = $51,000 + $560 (collected premium) = $51,560)

1 January 625 call expires worthless, premium is yours to keep

1 January 650 call expires worthless, premium is yours to keep

The total realized gain here is $153,160, including the premium collected from selling the covered calls. We've now sold 300 of our 500 shares for a large gain. Like the 1000 share position, we can repurchase the sold shares whenever we want or can continue to write covered calls against the remaining position.

Now there are some risks involved with covered calls. Since the calls are "covered" by the stock position, the only real risk is missing out on big upside return if the stock runs. That's in this case, with a very low cost basis relative to the current trading price. Though it doesn't apply in this example, you should never write covered calls on a losing position that will get your shares called away for a realized loss.

It's also important to remember when to sell covered calls. When Apple fell from $705 to $505 earlier this year, it would be a bad idea to start selling covered calls in the low-$500 range. This would result in all of your shares being called away at a lower price, especially if you expect Apple to trade higher in a relatively short period of time.

In this case, the premium collected from the covered calls resulted in a 1.2% return. Let's assume none of your shares get called away and you can repeat this process once a month for the rest of the year. You'll be able to generate an annual return of 12%-14%, in income alone. To reduce the risk of getting your shares called away, you can choose higher strike prices while reducing your annual return to around 4%-6%, which is still a good return. To increase your return to say 18%-20%, you'll run the risk of getting your shares called away, which is okay as long as you're comfortable with it.

Using options can create unique and advantageous income strategies when dealing with a company such as Apple. By being nimble and choosing accurate strike prices, you can reduce the risk of being assigned, allowing you to hold on to your position and continue to sell calls against it. Options aren't for everybody, but can be a great option, no pun intended, for those looking to generate a little income and are comfortable with selling your shares, with or without the intent to repurchase them at a later date.

Source: Is Apple An Income Stock? Depends