Consider Covered Call Investing! Why Limit Your Stock Holdings Income to Dividends?
Covered Call Investing is a term that we should distinguish from ‘covered call trading’. The difference between ‘investing’ and ‘trading’ is that traders only plan to buy and hold for the short term with a view to quick turnover of stock and hopefully, profits.
The ‘investor’ on the other hand, is usually described as one who has some attachment to the stock and plans to hold for the longer term, in the hope of ultimately receiving some capital gain, plus tax effective income in the form of dividends.
Now that we have explained the difference, let’s explore some covered call investing strategies for the longer term investor. The market price of stocks is continually in a dynamic state of rise and fall and it is this we need to pay attention to, but over the longer term than a trader. As a consequence from a technical analysis perspective, we would be more interested in consulting “weekly” stock charts than “daily” ones. We would draw trendlines, together with horizontal support and resistance lines, along the peaks and troughs of the weekly bars of the chart. Our aim is to observe a pattern. Once we recognize such a pattern, we then wait for an opportunity to buy the stock at the lower end of it.
Our covered call investing strategy would begin with our belief that the stock is close to a strong price support area. The best support areas are those which are confirmed by TWO converging trendlines – for example, an upsloping line along the troughs that converges with a horizontal support line based on where the ‘resistance’ level has now become support, historically. This is not entirely necessary, but when it is available, it gives us greater confidence.
Alternatively, you may wish to choose a good strong ‘blue chip’ company whose shares have taken a dive following the release of some adverse news or earnings report. You buy the stock in the belief that the market has only panicked in the short term but in the longer term, the price will recover.
Covered Call Investing – Step One
The first step in our strategy involves selling ‘out-of-the-money’ naked PUT options with a strike price at the support level at which we are prepared to purchase the stock. You will receive some income from this, which effectively serves to ‘discount’ the price you pay for the stock when exercised. The idea is to be exercised on the options, so sell your naked puts when there is only about 2 weeks to option expiration if possible, otherwise the stock may hit your anticipated level, then bounce north without them being assigned to you.
Covered Call Investing – Step Two
Once you have the stock, your second step, is to now sell CALL options at a strike price above the stock purchase price. You will receive further income from this, which again, will further decrease the effective purchase price of the shares and lower your overall risk of holding them.
The best conditions for covered calls are when the stocks you either own, or have just purchased, are trading in a narrow range over the longer term. You can use this strategy to receive an extra income stream apart from dividends, since your belief is that you’re unlikely to receive much in the way of a gain on the shares themselves. As such, if you use a stock screener to search for optionable stocks with low ‘historical volatility’ (HV) but also with reasonable liquidity (at least 500,000 shares traded daily) then your covered call investing has a high chance of success. Buy them at the bottom end of the narrow range and sell your call options. Keep doing this each month or whenever you see the opportunity and you are unlikely to be exercise and have your shares called away.
Covered Call Investing – A Cheaper Alternative
An alternative to a regular covered call strategy as described above is, that instead of risking a greater amount of capital by purchasing the shares themselves, buy deep-in-the-money ‘leap options’ on the stock. These are options which an expiration date of at least one year out. The effect is like owning the shares for a year but for a fraction of the cost. Sell short call options with a short term to expiration above the strike price of the ‘leaps’ and receive a monthly income.
The above strategy is usually called a ‘calendar spread’ and has been described as the “poor man’s covered call investing strategy” due to the lower amount of capital at risk. Calendar spreads can have different structures, risk profiles and outcomes but this is one of them.