A hot topic for some time now has been the purchase of dividend yielding stocks from solid companies, in order to produce continuous income. There is much talk about the "best" choice or choices, but I would like to focus on what has been my dividend stock of choice, Intel (NASDAQ:INTC), and how one can make a significant amount of additional income by writing simple covered calls against their position.
Covered calls are explained here:
"A covered call is a financial market transaction in which the seller of call options owns the corresponding amount of the underlying instrument, such as shares of a stock or other securities. If a trader buys the underlying instrument at the same time the trader sells the call, the strategy is often called a "buy-write" strategy. In equilibrium, the strategy has the same payoffs as writing a put option.
Writing (aka selling) a call generates income in the form of the premium paid by the option buyer. And if the stock price remains stable or increases, then the writer will be able to keep this income as a profit, even though the profit may have been higher if no call were written. The risk of stock ownership is not eliminated. If the stock price declines, then the net position will likely lose money."
The long position in the underlying instrument is said to provide the "cover" as the shares can be delivered to the buyer of the call if the buyer decides to exercise.
This is a strategy which can be employed on any number of stocks that have weekly or bi-weekly options, that one is neutral-to-mildly-bullish on. It is especially effective and sound if the individual carries those sentiments, and had planned to "buy and hold" for a year anyway. Microsoft (NASDAQ:MSFT), Johnson & Johnson (NYSE:JNJ) and IBM (NYSE:IBM) are all reasonable choices for this strategy. You could even do this with the tech darlings Apple (NASDAQ:AAPL) or Google (NASDAQ:GOOG), although it will require a much larger initial investment. The key here is choosing a solid, large cap investment that shows reasonably good prospects for the future. Stocks which pay a dividend are an added bonus.
I will be employing this practice myself throughout the year.
For this article I would like to focus on writing covered calls for Intel in order to generate income, both from sale of options and from the dividend yield (currently 21 cents per share), which Intel provides.
To begin, I will take $26,700 and purchase 1000 shares of Intel at $26.70 each. Immediately I will write call options against my 1000 shares, or 10 $27 call options, one step out of the money for proceeds of $16 per contract, or $160. After fees, this is a net gain of $142.50, or 0.534%. (Your fees may vary depending on broker and trading frequency.) Keep in mind these are weekly contracts, and a half percent does not sound like much, but when factored into 52 weeks per year, the yield becomes significant. This number is your minimum.
Depending on how the share price moves within the week, you will find yourself with one of two possible scenarios.
Intel appreciates beyond $27 per share and your shares are called away.
Intel stagnates or depreciates, and does not go over $27 per share, and your shares remain with you.
Each case has a minimum and maximum reward. We are not particularly concerned with the underlying stock price in terms of loss/gain, as we would have held our shares long anyway.
For scenario 1, the gain is the difference in price of purchase, to the strike price of the option. Here, it is 30 cents per share or $300, and beyond this you get to keep the $142.50 premium for your options. This is 1.657%
For scenario 2, the gain is the premium received for the options only, or your gain of 0.534%.
The next week, you will do the very same thing as you did to start. If your shares were called away, take your proceeds and purchase 1000 shares of Intel again, and write 10 calls 1 strike out of the money. Keep the rest in cash, until you are able to purchase a total of 1100 shares of Intel, and then at that time write 11 calls.
These percentage gain numbers do not sound large, but consider them compounded, over 52 weeks, employing this strategy over and over and over again. Compounded, one can expect a rough gain of 35% minimum, and up to a 135% rough gain, maximum. These numbers figure in Intel's dividend yield at $0.21 per share per quarter as well.
As with any strategy, this is not a "sure thing" as a massive decrease in the underlying share price or bankruptcy of the company can result in large overall losses. Since we are doing this with a stock we would have held long anyway, and we give ourselves plenty of room to "exit" our position at a moment's notice on a sharp decline, if we so choose, we give ourselves great income in the meantime to hedge against loss, or build our position. The only reason not to employ this strategy on stocks you intend to hold is if you are very bullish on a stock, and expect rapid appreciation, and this strategy allows you to evaluate this as often as you please, without being locked into longer term options.
I will re-visit this topic in the future, hopefully on a monthly, but at least on a quarterly basis, with updates on my gains or, if any, losses.