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Covered Call Writing Strategy For Income- An Introduction

Many investor's portfolios include investments such as stocks, bonds, ETF's, mutual funds and the like. However, the variety of securities you have at your disposal does not end there. Another type of security, called an option, presents a world of opportunity to sophisticated investors.

For many, the word "option" in the world of equity investments has a negative connotation, implying sheer "speculation" and extreme "risk". And why not, after all, anyone who has investigated option investments has read this disclaimer; "Options involve risks and are not suitable for everyone. Option trading can be speculative in nature and carry substantial risk of loss. Only invest with risk capital"

It would then seem that options are certainly not to be utilized by those in their retirement years or anyone else for that matter who wants preservation of capital and may be using their portfolios for income.

However, there is an option strategy that I suggest can be used with a portion of your portfolio to produce a very nice income stream to enhance any dividend growth strategy an investor is currently utilizing.

The strategy is called "Covered Call Writing", and is sometimes referred to as "buy-write". The following will describe how a covered call strategy, (selling calls against stock positions), fits into a total return portfolio with an emphasis on cash flow and income. I recommend that all investors should remain open to an approach emphasizing all types of strategies that enhance the total return on your holdings. I use this strategy on a portion of my portfolio as a "supplement" to the income derived from my total equity positions which consist primarily of dividend growth stocks.

A "covered write" has two parts, the underlying stock and a "call" option sold by the owner of the stock. Simply stated, a call option gives the buyer the right, but not the obligation, to buy a stock at a specified price for a specified time.

This is most easily understood with a picture and a "real' example. Let's take a look at Las Vegas Sands (NYSE:LVS), whose stock closed at a price of $74.58 on Tuesday 7/29 and the August 75 call was $1.22 bid, $1.26 ask.

As the Buyer you own the Aug. 75 call, you have the right, but not the obligation, to buy the stock at $75/share (called the "strike" price) at any time through August 16th. (The monthly series of options expire on the third Friday of each month). It should be noted that certain stocks also have weekly expiration dates adding more flexibility to this strategy, which in turn adds to the attractive nature of using options. LVS is one of them, however, for the sake of simplicity, I will only use the monthly expiration series in my explanation.

If the stock is above $75 on that date, you would exercise the call, claim your stock at a price of $75 and (perhaps) sell it at the higher price to lock in your profit.

However I am a seller of the call option, so by selling the Aug. 75 call, I have the obligation to deliver stock to the owner of the call. If I own the stock (which I always do- thus the "covered " notation), and the price is over $75 on expiration day, I will probably be "assigned" on the call and the stock will be "called away" at a price of $75. If you do not already own the stock (a naked short of the call or "uncovered", not discussed & not recommended here) you are now short the stock at a price of $75. I never get into this type of trade, as that is truly speculative in nature.

In summary, by owning the underlying stock and selling a call you collect the call price, called a premium. In my example that is $.78 The call has a specific date (August in my example) and a strike price, $75 in this case. If the stock is still below $53 at expiration, the call expires worthless and you pocket the premium while still owning your stock. Since each call sold represents 100 shares, lets take the example that I purchase 500 shares of LVS and simultaneously sell or "write" 5 of the Aug. 75 calls. The following chart shows the trade. ( I deduct $10 from the Call premium income as a "commission" )

By selling the call (referred to as "writing the call" in options terminology) the owner of the stock has pocketed some extra cash, but given up on the gains beyond $75 per share. The extra profit may seem small, but in the chart above its a 1.6% gain in less than a month (18 days to be exact) if the stock stays flat and is not called away. IF the stock is higher than $75 and called away, (the ultimate objective) the profit jumps to 2.1% for the 18 days that this trade lasted.

Please keep in mind that due to the timing of writing and publishing this article, I chose a situation in this example that is current and actual to illustrate the procedure. As you will see later on, the typical trade will be for about one month or so in duration and will yield anywhere from 2.5 to 3%. When one starts to annualize these percentage gains its easy to show how this strategy will add sizeable income to a portfolio, as will be demonstrated in the spreadsheet of the actual portfolio later in the article.

I added the column for dividends to the call income spreadsheet because there are times when you as the owner of the stock will receive a dividend while you have sold a call against your position, (commonly called double dipping).

In my example I chose the Aug. 75 call , as you can see there are many other alternatives , i.e you could have sold the Aug. 74.50 or go out another month to September and sell the 75 call. This flexibility adds appeal to this strategy of generating additional income.

The results of the initial trade and the Sept. option trade are shown for comparison below.

Now note the results if the stock is not called in September the profit is 2.3% and IF called it is now 2.8%.

Selecting the right call to sell requires a "feel" for the market and the particular stock that you are holding or buying to deploy this technique . However it's not something that takes years, it can be achieved in a relatively short period of time.

In summary, your choice of calls depends upon your expectations for the stock. If you are more cautious, you may want additional downside protection.

I like to select the near-term options. Going out 1 to 2 months, so I can turn over the stocks, re-cycling the money, generating cash flow, and keep the premiums rolling in. I usually try to stay away from a scheduled earnings announcement. It simply adds too much volatility and I don't want volatility to the downside when writing calls for income. There are plenty of stocks to choose from, why add another "risk " to the equation.

When you go out about 1 month in the option series it gives you, the seller, the greatest "time decay". As the option moves closer to expiration, the fewer days remaining translates into less "time value". Bad for the owner, but great for the seller. Each month you can write a new call, this does require active management and work. Nothing in life comes for free, if you want income you have to work for it.

Once developed, a covered call strategy provides an enhanced month to month income stream. The "small " monthly percentage profit associated with it is why many investors who don't understand the "total return" and "income enhancement" features of this strategy, totally ignore it.

The argument is that this strategy "caps" your upside gains. For sure it does, but as you will see from my "actual" trades in the accompanying chart both here and as documented on this blog, it adds a nice income stream, and if done correctly can outperform the major averages. As cash flow is generated you can continually re-cycle the money from positions that are called away. It's like hitting a lot of "singles" instead of hitting a "home run" or what nobody ever wants to talk about "striking out".

There are two parts to finding a good covered write position, the best stock and selling the right call. Many tend to automatically focus on the maximum return or the greatest percentage from the call. In my view, that is a mistake. A larger call premium reflects extreme stock volatility, in my view, a synonym for risk.

Some will disagree with me on that point, but I prefer starting these positions by finding a stock with good fundamentals. Purchasing the stocks of strong companies, some with reasonable dividends, (but not necessary for success) and enhancing your yield by selling near-term calls. I maintain a list of about 10-15 candidates to draw from, updated for changing prices and market conditions, as I put the trades on from month to month.

Staying on the "right stock" issue, this is not a primer for stock picking, but you will find with practice and experience some stocks are particularly suitable for writing calls. However, one point I continue to stress, select a stock that you would not mind owning in your portfolio in the event the shares are not called away in a market decline. It always helps to have a viewpoint of the overall direction of the market, but by selling calls against your position there is some flexibility.

It sure looks and sounds great but what are the risks?

The biggest risk to a covered write position is that the stock declines. Of course, this is the same risk that you have with stock ownership, but with this strategy you do get some protection from the sale of the call option.

Thus the single most important rule comes back into play - select a stock that you do not mind owning in your portfolio. I have seen many choose volatile stocks just to get the enhanced call premium, only to be left with a portfolio of stocks after a market decline that they wouldn't own otherwise, it's a sure recipe for disaster.

Many can't grasp this concept, buying a stock that I wouldn't mind owning, but hoping it gets called away ! Yes, that sums it up, many do grasp the concept rather quickly after they see the income roll in. I often refer to this part of my holdings as the "rent a stock' portfolio.

This "Call Writing for Income" portfolio was started in my SA Instablog, where all trades were posted and documented.

The following table represents the 'actual" portfolio positions with the results attained so far during 2014.

The "shaded" positions are 'expired" or "called away" leaving this portfolio with 5 open stock positions as of 7/27.

This is an "actual" portfolio, that was started June 5th 2013, with $100,000. The chart shows the total income generated to date to be $28,740. As one can see the perceived "small" premiums do add up quickly. The same $100,000 invested in (NYSEARCA:SPY) on June 5th @161, would now be valued at $122,795, without the monthly income stream nor the flexibility of having access to a portion of the original investment. The latest trade is posted here.

As stated, I use this strategy on a 'portion" of my holdings to increase income and view it as another weapon in an investors arsenal in the search for portfolio yield. It is not being portrayed or intended to replace sound investment principles such as a solid dividend growth portfolio or other income strategies.

Past performance is no guarantee of future results, however, it is my intention to continue to provide information with a series of future blog posts to document both the trades and results of this strategy. I invite ideas, suggestions as the trades are executed to follow along and check the results.

Best of Luck to all

Disclosure: The author is long EBAY, NUAN, FCX, LVS, NVDA. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long numerous equity positions - all of which can be seen here on my Instablog. It is my intention to present an introduction to these securities and state my intent and position. It should be used as a 'Starting Point' to conduct your own Due Diligence before making any investment decision. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.