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As promised, part 3 of this "newbie" series (and anyone else that would like to review from square one) will be on writing covered calls on our portfolio to make some extra income.

Our "Initial Core Portfolio" consists of Exxon Mobil (NYSE:XOM), Johnson and Johnson (NYSE:JNJ), General Electric (NYSE:GE), Annaly Capital (NYSE:NLY), and AT&T (NYSE:T).

Part 2 of our series was about allocation of available funds, and what stocks would be a great starting point for new dividend/growth investors heading towards retirement, or those just retired and seeking more income as well as a lower risk portfolio.

Let's take a look at our portfolio;

StockSharesValueYield %
XOM1008,6002.20%
JNJ20013,0003.50%
GE70013,3003.60%
NLY2003,40013.60%
T70021,0006.00%
TOTALSX59,3004.75%

As you can see we have a specific number of shares purchased for each stock based on dividend yield, recent share prices (as of 1/30/2011) and percentage of our available funds. We do not want to be too heavy in any one stock, nor do we want to reach our intended total percentage in any stock all at one time.

We began our journey with $100,000 in available funds to invest and we currently have roughly $40,000 in cash reserves to deploy in future chapters. ( For the advanced strategy readers, we have determined that the market could be ready for a correction, so having cash on hand right now is VERY prudent)

Let's Sell Some Calls

First, let me give a brief overview of what selling (or writing) calls are; the share holder sells options (calls) to give someone the rights to the shares at a defined price, by a particular date. The buyer of the calls pays a premium to the shareholder, which is the added income derived from actually owning the stock and implementing the strategy.

Bottom line is that once you sell the calls at a strike price over the current share price, you get the premium from the sale immediately and you can do whatever you want with the money.

For our purposes, we will put the premiums received into our cash reserves to build that up for future stock purchases.

The next step will be to review each stocks "option chain" and select the ones we are most comfortable with.

We have selected the following calls to sell:

XOM: 3/16 expiration: $90.00 strike price: $30.00/premium received
1 contract sold equals 100 shares at $.30/share premium

JNJ: 3/16 expiration: $67.50 strike price: $20.00/premium received
2 contracts sold equals 200 shares at $.10/share premium

GE: 4/20 expiration: $21.00 strike price: $90.00/premium received
7 contracts sold equals 700 shares at $.13/share premium

NLY: Skip this cycle. The premiums are too small

T: 4/20 expiration: $32.00 strike price: $85.00/premium received
7 contracts sold equals 700 shares at $.12/share premium

By selling the calls as we listed we would immediately add $225.00 to our cash reserves which would now stand at $40,925 for use to deploy at some point. We can add shares of what we own, or add new stocks to our portfolio.

In Part 4 of this series we will explore our choices and decide what looks best.

What Happens Now?

Let's look at the downside first:

1) The stocks take a huge hit, and you cannot sell them because you have promised them to the "call" buyer; unless you buy the calls back, and take action on the stocks themselves. (Remember we still own the stock so nothing is actually lost)

2) The stocks sky rocket and you missed the boat because they were 'called' away by the owner of the calls you sold. Which can be mitigated by rolling over the calls to a further out date as you get closer to expiration date. (We made a profit anyway!)

Those are the two worst case scenarios that I can think of, and that I have personally faced as well.

Let's look at the upside:

1) The price of the stock stays under the price we agreed to sell it at, and does not drop that much. We keep the premium and do the strategy over again.

2) The stock prices rise and the shares are called (or taken) away. We sold the stocks at a higher price and made a profit, collected the dividend, collected the premium from the sold calls, and now we can use the cash to buy the shares back immediately or wait for an even better purchase price.

That's it. Nothing magical, just a simple strategy that gives us some extra profits simply because we own the stocks. As you can see, the upside far outweighs the downside risk and is a strategy that we use ourselves all of the time and we would urge everyone to see if the strategy is for them.

My Opinion

Now that our newcomers have a basic understanding of our option strategy, we can move ahead to expanding our core portfolio.

Part 4 will explore our choices and which ones will serve our purposes best. Reduced risk, solid companies, good dividend yields paid on a regular basis.

Stay tuned, it gets more interesting all the time!

Disclaimer: Please remember to do your own research prior to making any investment decisions. This article is not a recommendation to buy or sell any securities or stocks and is the opinion of the author.

Source: Retirement Portfolio Fundamentals (Part 3)