Options investment done right can make you a safe annual income. Here’s how.
Writing covered calls. Many of you have heard about writing covered calls. Some of you may already do it. But there are safety rules you need to know to profit from this options investment.
First, here are the basics, so we’re all on the same page.
A call is a type of option. A call owner has the right to buy a stock at a fixed price up until a date when the call expires. People buy calls hoping the stock price will go way up. Using the call, they could then buy the stock for less than the market price.
Calls are created by people like us who “write” the call – sell others the right to buy a stock from us at a fixed price. We get to keep the money we’re paid, regardless of what happens with the call.
The premiums we’re paid for writing calls can be a source of regular income. You can write calls on the same stock again and again. When one call expires, you can write another.
There are three possible outcomes when you write a covered call:
- The stock goes way up. The buyer exercises his call option. You sell your stock for a small profit plus the premium you received for writing the call.
- The stock stays about the same. The option you wrote expires worthless. You keep your stock plus the premium you received for writing the call. You can write another.
- The stock falls. The option you wrote expires worthless. You keep your stock plus the premium you received for writing the call. The premium reduces your loss on the stock. You can write another call.
You’re ahead in any of these scenarios.
Only write “covered”calls – you must own the stock. If a call is exercised and you don’t already own the stock, you have to buy it on the open market to get the shares to sell the call owner. You might take a big loss.
Write calls that will expire in less than three months. You won't have long to wait until they expire and you can write new calls. Many small profits on short-term calls mount up, and they're safer than chasing the big premiums on long-term calls. The longer the wait, the less the certainty.
There are two potential risks to covered call writing:
- The stock falls so far that your call writing premiums can’t make up for it. The stock collapses.
- The stock soars, but you have to sell to the call owner at much less than the market price.
Here’s how to avoid them:
- Only write covered calls on safe stocks that you buy at bargain prices. Learn how to recognize safe stocks at Safe Money. You can also get some good ideas at Two Tips For Spotting Safe Investments.
- Only write covered calls on stocks you would not mind selling at the agreed upon price. If you expect a stock to soar, this is the wrong options investment.
Write covered calls regularly on safe stocks, and an annual income of 15% to 20% can be yours.
Here are three promising covered call writes:
- Sell October $65 calls on Alexion Pharmaceuticals (NASDAQ:ALXN), a leading drug maker. You get $1.10 per share for each call contract you sell. That's a 1.9% return on ALXN's $57.65 price. 1.9% in two months is 11.4% simple interest in a year. The probability that ALXN will pass $65 by October 22 is only about 20%, so the call is likely to expire unused. ALXN is a safe stock unlikely to collapse.
- Sell October $70 calls on Whole Foods Market (NASDAQ:WFM), a leading food retailer. You get $1.61 per share for each call contract you sell. That's a 2.6% return on VFC's $61.13 price. 2.6% in two months is 15.8% simple interest in a year. The probability that WFM will pass $70 by October 22 is only about 29.5%, so the call is likely to expire unused. WFM is a safe stock unlikely to collapse.
- Sell October $115 calls on iPath DJ-UBS Sugar Subindex Total Return ETN (NYSEARCA:SGG) which tracks the price of sugar. You get $3.80 per share for each call contract you sell. That's a 3.8% return on SGG's $99.90 price. 3.8% in two months is 22.8% simple interest in a year. The probability that SGG will pass $115 by October 22 is only about 23.4%, so the call is likely to expire unused. Sugar is a seasonal commodity now in its annual upswing, so it is unlikely to collapse.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.