“Insurance” Payments On The Stocks You Own? Here’s How
Many investors own stocks and simply hope that dividends and capital gains will be enough. The problem, though, is “hope” isn’t a strategy.
Studies show that most individual investors underestimate how much money they’ll actually need during retirement. And I’m willing to bet, if you’re being honest with yourself, you may quietly admit that you’re a little worried yourself.
Thankfully, I’m about to show you a strategy that can help you get to where you want to be.
Think of it as writing “insurance” policies for the stocks you own.
In this case, you get to act as the insurance company — writing “just in case” policies for the stocks in your portfolio, and earning a hefty premium payment for your trouble — immediately.
Allow me to explain…
Introducing Covered Calls
For those who haven’t guessed yet, I’m talking about covered call options. For those who are unfamiliar, covered calls let you make a deal with other traders who want to pay you cash upfront for the opportunity to buy a stock you already own at a higher price.
That money goes straight into your brokerage account. You collect the cash they pay to make the deal immediately (again, we like to think of this as an “insurance policy” — I’ll explain why in a minute). And you still get the opportunity to sell your shares for a profit down the road.
Sounds pretty good, right?
Of course, there are some things you need to understand about this strategy first. I’ll get to those in just a moment.
But the nice thing about covered calls is you can use this strategy to generate income for day-to-day living costs… monthly bills… medical expenses… even have enough additional income for things you otherwise couldn’t afford, like a lavish vacation.
However often you do it and however you use the income — the power is in your hands. It’s one of the easiest, most conservative ways around to generate extra income.
Just ask my colleague Amber Hestla, head of Profitable Trading’s Maximum Income service. Amber and her premium readers use this entry-level options strategy to earn hundreds of dollars — sometimes even thousands — in extra income with each and every trade.
An Example Of A Covered Call Trade
A covered call strategy is incredibly simple to learn. For every 100 shares of a stock you own, you can sell one call option against it. That’s the “covered” part. By selling calls, you generate upfront income, also known as a “premium.”
Let me give you an example… (Keep in mind, this is not one of Amber’s official recommendations. Because options prices are fluid, I’m using nice round numbers based on recent prices. So it’s for illustrative purposes only.)
Let’s say you want to use this on shares of the energy refiner Phillips 66 (NYSE: PSX). As I’m writing this, shares are trading for about $85. Let’s say you own 100 shares.
You could sell a call option on Phillips 66 that expires on April 16 with a strike price of $90 for about $2.00.
This means if you execute this trade, you’ll earn a premium of $200 ($2.00 x 100 shares). That’s a return of about 2.4% ($200/$8,500).
That may not sound like a whole lot, but it’s also more than half of PSX’s current yearly dividend payment. And you get it all at once.
What’s more, this trade expires on April 16, which is less than a month from now. You can then turn around and make a similar trade all over again, as long as the stock price stays below $90 by the time the options expire. (As an added bonus to continue holding shares, you can keep collecting the regular dividend payments, too.)
On the flip side, if the share price rises to $95 or above, you’ll sell the shares at $95. If you bought those shares at $85, that would give you a net profit of about 14.5% in less than a month. (The $2 premium reduces your cost basis to $83.) That’s not bad for what would amount to a short-term trade. (And if you were fortunate enough to own PSX already, then the math gets even better…)
How To Win With Covered Calls… Even When You’re Wrong
Since you earn this income upfront, this offsets some of the downside risk in the stock. The premiums you earn effectively reduce your cost basis, as shown in the example above. And because you own the shares, you still get to participate in some of the upside.
That’s why we like to say that covered calls are like “insurance” policies on your portfolio. Because they can really save your bacon when the market takes a turn.
Let’s say you bought 100 shares of Phillips 66 thinking the shares would rise. But something happens that you didn’t anticipate (like a dip in energy prices, or a broad selloff in the market) and the stock plunges by 5% (to $80.75).
If the stock remains below $95 by April 16, you’ll still keep the $200 per contract and continue to own the stock. But remember, that premium reduces your cost basis to $83. ($85 per share, minus the $2 premium you received.)
So what would have been a 5% loss is now only a 2.7% loss. While it’s not idea, it helps soften the blow a bit.
And since you had enough faith in the company to buy shares in the first place, you can sleep a little better at night. Regardless of whether the stock rebounds quickly or not, you can keep selling covered calls on the position to earn income and lower your cost basis further. (Again, let’s not forget those regular dividends, either, which can help soften the blow until the price rebounds.)
How To Start Using Covered Calls
In this market, safe (and high) income is tough to find. Selling covered calls on high-quality stocks is one of the best — and easiest — strategies available to regular, everyday investors. Even better, it’s perfectly scalable. So in our example, if you bought 1,000 shares and sold 10 calls, you’d $2,000 upfront.
And as I mentioned before, you can repeat trades like this again and again…
That’s not to say covered calls are risk-free, of course. No investment is. But there’s a reason high-tech hedge funds and old-school value managers alike use covered calls… they can help you reduce risk and pay you to wait. It’s a no-brainer in more ways than one.
Right now, my colleague Amber Hestla has a special report detailing how she and her followers use this strategy to earn thousands in extra income per month.