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I recently wrote about my No. 1 income strategy for this low-yield environment. Now, it might not have been the most exciting strategy. But when you consider the paltry yields being offered in other corners of the market, it is exactly the kind of thing that should get your heart pumping as a trader. Sure, you may not book triple-digit gains, but you can earn consistent -- and safe -- income with it.
And that's not to say the returns can't be spectacular. I've used this strategy to book annualized gains of up to 247%.
Some of you may know that I run a premium service called Maximum Income, in which I recommend covered call trades, providing in-depth research on the best stocks to trade for income and specific instructions on how to enter and exit the trade.
While I'd love for you to join my Maximum Income community and trade alongside me, today I want to provide you with some of the tools necessary to make covered call trades on your own.
I can't stress enough how important it is to get your hands dirty with this stuff. Similar to learning a foreign language, the best way to improve is through immersion.
There are four rules I follow to earn double-digit yields when selling covered calls. Once you understand the finer points, you can use these steps to find your own option trades as you pursue income opportunities.
1. Only sell covered calls on stocks you want to own.
If you can follow this one rule, you'll be ahead of 90% of option traders.
To recap, a covered call strategy involves selling call options on a stock you just bought or already own.
When you sell a call, you generate income, known as premium, upfront. But since you're required to own the stock you sell calls on, you want to make sure you're more than comfortable holding the shares for the long term.
Since you own the stock, you will benefit from any capital gains and dividends, just like a regular shareholder. And while the income from selling the call offsets some of the downside risk, it's important to look for quality companies that have a good reputation and are not likely to suffer an unexpected drop on bad news.
Ideally, you won't have to look far. A good covered call candidate may already be sitting right in your portfolio. If so, great. If not, the most important question to ask yourself is, "Would I want to own this stock even if I wasn't going to sell covered calls on it?" If the answer is "Yes," then you're in business.
2. Determine a buy price that offers you a suitable margin of safety.
When you purchase a stock, you want to make sure you're paying a fair price for it. You can apply the standard valuation metrics you normally use, but my personal favorite is the PEG ratio.
The PEG ratio compares a stock's price-to-earnings (P/E) ratio to its earnings growth rate. This indicator recognizes that stocks with faster earnings growth should have higher-than-average P/E ratios. A PEG ratio of less than 1 indicates a stock is undervalued.
The PEG ratio is by no means perfect, but the point here is to do your research. Ultimately, you want to ensure you're buying a stock at a price that's below fair value in order to provide an adequate margin of safety.
3. Pick the right option.
Screening for suitable options is a multistep process, and I recommend the following criteria:
Choose call options that expire in less than 90 days. I prefer short-term options because they allow me to roll over trading capital several times a year, which maximizes profits. It also gives me more flexibility since my money is never tied up for longer than three months at a time.
Pick call options that are "out of the money." This simply means that the call's strike price is higher than the market price of the stock. This allows me to participate in the stock's potential upside. I typically recommend options that are somewhere between 3% and 7% above the current share price.
Sell options with an annualized return of at least 10%. You want to make the trade worth your time, so shoot for a return that will deliver a good amount of income for your effort. Everyone's preferences are different, but my recommendations typically fall somewhere in the range of a 10% to 20% annualized return.
Make sure there's adequate liquidity before entering the trade. The more liquidity an option has, the easier it is to enter and exit the trade at the price you want. Generally, I look for options with bid/ask spreads below $0.50 and open interest of at least 400 contracts.
4. Verify the data, execute the trade and then follow along.
I know this sounds like a no-brainer, but you'd be surprised by some of the discrepancies you'll find between various free websites compared to what your broker quotes you. As the old saying goes, "Trust, but verify."
Once you execute the trade, it's important to follow along to see how it's faring. The market is ever-changing, and you should be prepared to adapt accordingly -- especially if you want to sell covered calls on the stock again. I personally monitor all the trades in the Maximum Income portfolio each and every day and alert my subscribers if any action is needed.
My hope is that I have provided you with the framework to start trading covered calls whether you decide to follow along with my Maximum Income newsletter or not.
And if you'd like more information on trading covered calls, I've put together a free presentation called, "How to Pocket an Extra $3,000 a Month Using Entry-Level Options."
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