Selling Covered Calls For Income

 

You need money and investments in place for a comfortable retirement. Everybody knows that.

 

It’d be nice to also have some consistent income before then, right? It’s widely accepted that stocks and options can provide the means for a secure and comfortable lifestyle…if you know what you’re doing.

 

First off let me start by saying you can achieve consistent income from selling covered calls. And by consistent I mean month after month and year after year. After all, what’s the point of making great money in the market only to lose it all with one careless YOLO trade.

 

If you want to generate income from covered calls you have to figure out how much you’d like to make…then work your way backward.

 

Selling Covered Calls

 

Let’s say you want to generate an average of $5,000 a month in covered call income. Next, let’s also say that you’re a somewhat conservative investor and you don’t want much volatility in your portfolio. With that income goal in mind, you’d typically expect to earn between 3-5% a month from writing covered calls.

 

Since you’re looking to earn 3-5% a month from covered call writing and you expect that 3-5% to generate $5,000 in income, that would mean you would need to have a portfolio of stocks that had a combined value of between $100,000 to $167,000.

 

The way you arrive at those numbers is to take the amount you would like to make each month ($5,000) and divide that by the percent you are aiming for (3-5%). This in turn tells you how much money you will need to achieve those returns.

 

$5,000 / 0.05 = $100,000.    $5,000 / 0.03 = $166,666 (rounded to $167K)

 

When you sit down and work out the numbers in this manner it really gives you a handle on how to plan your trading strategy and how long it might take you to reach your goal.

 

An important thing to keep in mind here is that this is the ideal scenario. You know that the market seldom moves in just one direction. And even if it’s in a long term trend, no trend will last forever.

 

Along the road to a $100,000 or even a $1 million portfolio are months of getting called out on your covered call positions, bad earning reports that cause our stocks to drop, and the everyday unpredictability of the market.

 

Covered call vs. Rental property

 

One way to think about stock ownership for the purpose of selling calls is to compare it to buying a piece of real estate as an income property.

 

An apartment building is not purchased with the intent to buy and sell it over and over again. It’s bought to bring in consistent monthly income by way of each apartment’s rent. Of course the value of the actual building will go up and down with the housing market, but those rents from each tenant will continue to come in regardless of the value of the property.

 

Owning covered calls and buying real estate are not that cut and dry, but it does help to illustrate the point of this strategy…to acquire an asset that produces a consistent cash flow.

 

The cost of the property and the cost of the shares of stock are the price to get in the game. Once you have the asset, be it stock, real estate or any other investment vehicle, you are on your way to producing income.

 

When do you really make money?

 

The three things you must always consider with any type of investment are when will you lose money, when do you break even, and at what point do you become profitable.

 

The first thing you should do when you enter into any investment is to figure out your break even point. Put another way, when will you have gotten the money back you put into the trade?

 

This is not only on a trade by trade basis, but on your portfolio as a whole. If you have a $50,000 portfolio you should figure out based on your average return, at what point you’ll make your initial $50,000 back. After you have recouped your initial capital this is the point at which you really start to produce profit. Think of it as the moment when you pay off the mortgage on your investment property.

 

How often will you get paid?

 

When you get paid will depend on a few factors. The first being what options expiration you use to sell your calls. With monthly, weekly and even those that expire five times a week, you have a lot of flexibility with how you manage your income.

 

If you choose to only focus on selling monthly call options, it can take away some of the stress of having to watch the equity so closely. With monthly options, you have around 30 days to figure out when to close your position. Depending on how the stock or equity moves, you can sometimes buy it back before the option even expires on the 3rd Friday and sell it a second time before expiration.

 

Although if you’re looking for low maintenance covered call income, you can just close it out as it nears expiration and sell the next month call.

 

Weekly expiring options give you the ability to get paid 52 weeks a year. While you can make more selling weekly instead of monthly options, you can also lose money more often as you only have five days for your stock to move in your favor.

 

In a volatile market, trying to produce income from selling weekly expiring calls can be a bit tricky. You could easily get a big move that puts your options deep out of the money only to have them move deep in the money the day of expiration.

 

It makes it all that more important to have a good strategy and plan for managing risk on your position.

 

One school of thought is to close out your position early if it reaches 80% of your expected profit target with 50% of the time left until expiration. If you sold a covered call for $100 in income and it was worth only $20 with two weeks until it expired, that could be a good time to buy it back.

 

With a move like that, the stock probably went substantially lower. By buying the calls back, you could potentially sell them back again if the stock recovers before expiration.

 

It needs to be said that stock selection is paramount for a covered call income strategy. In an ideal scenario you’d want a stock that isn’t very volatile, is trending slowly higher or at least sideways, and has options with a small spread. You want the spread on the options to be as small as possible in the event that you want to or have to buy them back, so you don’t loose much money on the transaction.

 

Selling covered calls on a stock that also pays a dividend would make it the perfect selection for covered call income.

 

Keep these things in mind and you may well be on your way to consistent income from selling options. Continue to review your portfolio on a regular basis as a great stock for covered calls today could be a terrible one tomorrow.