Thursday, 2 June 2011

A good call for higher income …

 

Nilus Mattive

In my latest issue of Income Superstars, I told my subscribers about a compelling way to get even more income out of many of the stocks I’ve recommended to them … and it’s a strategy that I’ve discussed before here, too.

But because I think we’re at a time in the markets when this particular approach makes A LOT of sense, I want to talk more about it today.

The approach is known as covered call writing, and while it involves options … it is both conservative and relatively easy to implement.

First, a quick recap of what options are: These contracts allow investors to buy (calls) or sell (puts) a given security at a given price (the “strike”) over a specified timeframe. Each options contract covers 100 shares of the security, known as a “round lot.”

Investors frequently use options as a way to hedge their portfolios or to speculate on a security’s future moves. One advantage of using options is that you put less capital at risk — because buying a contract allows you to control 100 shares for a lot less money than buying the shares outright. Plus, you have strictly limited downside, which is not technically the case with other speculative activities like short selling.

Of course, covered call writing carries even LESS risk than the usual options trades. That’s because rather than trading these “insurance contracts,” you’re selling them to someone else and collecting the premium (the price that investor is willing to pay for the option).

Now, the reason this is called covered call writing is because you are only writing calls on stocks you own.

Yes, it is entirely possible to create and sell a call for a stock you don’t own, but I DO NOT recommend doing it. Known as “naked” writing, it literally leaves you exposed to lots and lots of risk.

As I mentioned, options contracts always involve 100 share lots, so to write a covered call you will need to own 100 shares of a given stock. And that stock will have to be “optionable,” meaning there is an active market trading options on the shares. But don’t worry — nearly all the stocks you own are likely optionable.

Okay, so you’ve got your 100 shares of an optionable stock. Now what?

The first step is making sure your brokerage account is set up to write options. But this is easily accomplished with a simple form or two.

Next, you need to find out what kind of contract you want to write. This is really part art and part science, but the idea is typically writing contracts that are “out of the money.” In other words, you want to sell a contract with a strike price HIGHER than the underlying stock’s current one (or at least higher than the price you paid for the shares).

Let’s walk through an example to see why. To keep things simple, we’ll use 100 shares of a hypothetical stock that you just purchased for $30 a share.

After scanning the options market, you decide to write a contract that expires in September with a strike price of $35. You see that this contract is selling for $1.50. Again, because the contract covers 100 shares you must multiply the price times 100 meaning the actual premium you will collect is $150!

Now it’s just a matter of placing your order, either online or with your broker over the phone.

Once the contract is created and sold, you will receive the premium (minus commissions) in your account. This windfall is yours to keep no matter what happens next!

In other words, with covered call writing, you always collect a nice little “dividend” immediately. But your potential profits don’t stop there. The rest of the story can play out in a few different ways. Let’s go through each scenario one at a time …

If the stock price fails to rise above the strike price of the contract, the investor who bought your call option will let it expire worthless. You get to keep your stake in the company, plus the money you collected for the option. End of story.

The same is true if the stock goes nowhere or down during the life of the contract. And it’s even true if the stock temporarily goes above the strike price but the investor holding your option fails to exercise it.

Also, once the contract expires you are free to write a new call with a new strike price and a new timeframe, which means you can continue collecting more and more premiums in the process.

Meanwhile, the last possible scenario is that the stock rises above the strike price and the investor exercises the option before it expires.

In this case, you will be forced to sell your shares to the options holder AT the strike price. This is your only obligation. You can never be forced to sell the shares at any price other than the strike price!

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In other words, the worst thing that can happen with covered call writing is that you will be forced to part with your shares for the predetermined strike price.

But think about what that means … essentially, you’ve made money from the sale of the option … from any dividends paid along the way … and from the exercise of the option itself (again, as long as you picked an appropriate strike price).

And you can always buy the stock back later if you want to!

In short, this is a great approach to use to get more income right now … especially with the stock’s momentum recently slowing.

Best wishes,

Nilus

P.S. And for more on advanced income strategies like covered call writing … plus details on all of the dividend stocks I’m currently recommending … just click here.

http://www.moneyandmarkets.com/a-good-call-for-higher-income-%e2%80%a6-44895

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