As a day trader who primarily spends their morning scalping options in our live options room, we only utilize a portion of the benefits that trading options have to offer. Scalping and day trading tends to be fast, directional, momentum plays that are held for a very short period of time. However, not everyone has time to day trade options. Luckily, there are ways one can incorporate options into their traditional portfolios to earn passive income. In addition to being a day trader, I am also an investor with a long-term portfolio. When it comes to my long-term investments, I tend to try and look for stocks that have a high dividend yield. By utilizing options, I can increase my dividend and earn passive income. And this strategy is called the “covered call strategy.”
What is a Covered Call?
As stated above, covered calls are one of the most effective strategies to generate passive income, especially on stocks that pay a high dividend and tend to be range-bound. The covered call strategy is when the seller of the call option/s owns the corresponding amount of the underlying security. For example, if you own 5000 shares of AAPL, you would sell 500 call option contracts, as each option contract represents 100 shares of the underlying.
An Example of the Covered Call Strategy
For example, let’s take a look at MO (Altria Group Inc.). MO has an annual dividend yield of 7.27%, meaning MO has a ratio of paying 7.27% of its share price in dividends. MO is also a very range-bound stock. Over the last year, the highest MO’s share price has ever been $52.50 per share, and the lowest it’s been is $36.08 per share. Over the past year, MO’s dividend yield has ranged between 6.9% and 8%, meaning that despite MO’s share price fluctuations, although minor, MO’s dividend yield continues to stay high. By purchasing shares of MO to receive a high, risk-averse dividend, we can earn passive income. However, in order to increase our monthly income from being a MO shareholder, we can also sell covered calls against our share position.
Here’s How it Works…
Since we have identified both the top and bottom of MO, we can now choose a level as to where we want to sell calls. For example, let’s say you own 1000 shares of MO and bought at near the high at $52 a share. At this time, MO has a dividend yield of 7%. 7% of $52 is $3.64, multiplied by 1000, which would equal a dividend of $3,640 a year. To increase the income you receive from being an MO shareholder, you can also sell monthly, $55 strike calls. Due to MO never being above $52.50 per share within the last year, it’s unlikely that it’ll break that ceiling. The $55 calls will also have low Delta. The Delta percentage of an option is considered to be the probability of your option being in the money by the date of expiration. It’s also ideal to sell calls on a day where MO’s implied volatility is slightly higher than usual, as the contract prices we are selling will be worth more money, and therefore, increasing our profits as the contract seller.
As we can see above on the option chain, for the month of September, at the $55 strike, the open interest has 7,028 calls that are currently open. If we were to sell 100 of these calls, it would cover your entire share position. If you were successful, you would earn an extra $600 a month, like 0.06 ($6 a contract) multiplied by 100 is $600. This $600 in premium is in addition to the $303 dollars you would receive as a dividend for being a MO shareholder, and your monthly income from MO alone would be $903. Let’s say you sell covered calls against your MO position every month, for 12 months, the same strike, and in theory, for the same price. $903 multiplied by 12 gives us a total annual income of $10,836 from being a MO shareholder. If we did not sell covered calls, we would be taking in the number stated above, $3,640 a year. Therefore, by selling covered calls, we increased our annual dividend income from MO by 60%!
What’s the Worst that Could Happen?
There are a few risks associated with the covered call strategy, however, they are scarce. The largest risk is if your contract expires in the money, by the date of expiration, in the buyer’s favor. This means that you as the contract seller would be obligated to transfer over your share position to the contract buyer. However, if you want to hold your share position, there is a way to prevent this, and it involves taking a loss- You can buy the short call back before expiration, take a loss on that call, and keep the stock. However, this is why we stick to range-bound stocks and sell calls above resistance, keeping the odds in our favor.
Learn the Covered Call Strategy in TRADEPRO Academy’s Options Course!
The Covered Call strategy is taught in TRADEPRO Academy’s Options Trading Course! Even if you don’t have the time to day trade, learning passive income strategies to incorporate into your long-term portfolio is taught and encouraged here at TRADEPRO Academy. Join us today and be a part of a knowledgeable community that caters to your specific needs and success.
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO AcademyTM is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.