Using covered calls to generate more passive income
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Weekly Market Update 🗒️💡
The Dow Jones rose 0.9% this past week, with the S&P 500 also adding 0.9% and the Nasdaq rising by 1.3%, in what’s considered Big Tech’s marquee earnings week.
The Dow Jones notched its best month since January, finishing 2.5% higher for the month of April. The S&P 500 closed out with a 1.5% monthly gain, its 2nd monthly gain in a row, while the Nasdaq’s increase was nothing substantial.
About half of S&P 500 companies have reported earnings so far this year and of those, 80% have BEATEN expectations.
Amazon closed down nearly 4% after reporting Q1 results noting its cloud business slowed down. However, the tech giant still managed to beat Wall Street’s expectations for revenue.
Snap fell 17% after missing revenue numbers and Pinterest shares dropped 15.7% after releasing bad Q2 revenue growth expectations.
Finally, shares of First Republic Bank fell more than 43% after CNBC’s David Faber reported that the regional bank is likely to be put into receivership.
The stock has lost more than 97% of its value since the start of the year. Tough look.
My take: the easiest way to block out the noise is to continue DCAing into your positions.
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Did you know that you can generate extra income from your dividend stocks?
Did you also know that you can turn non-dividend paying stocks into a cash-flowing asset?
Income from covered call premiums can be 2-3x as high as the dividends you earn from that stock.
In today’s post, I will be walking you step by step through the covered call process so you can start earning more passive income which you can then funnel back into the market.
What is a covered call?
A covered call is an options trading strategy in which an investor holds a long position in an asset, such as a stock or exchange-traded fund (ETF), and sells (writes) call options on that asset.
The investor generates income when they sell the call, known as the premium, and this transaction also creates an obligation to sell the underlying asset at a specified price, also known as the "strike price”, if the option is exercised by the option buyer BEFORE the expiration date.
In simpler terms, if you were to sell a covered call you would be selling someone else the right to buy your stock at a set price in exchange for a premium.
This is a solid strategy to use for long-term investors who want to generate additional income from their holdings, investors who want to turn non-dividend paying stocks into cash-flowing assets or traders who want to make extra profit from stocks trading sideways.
To better understand how covered calls work, let's look at an example:
Let’s say you own 100 shares of Stock ABC, currently trading at $50/share.
It’s your opinion that the stock price is unlikely to rise in the short term and you want to generate some extra income from your position.
You decide to sell 1 call option contract. 1 call option contract represents 100 shares. If you were to sell 2 call option contracts, that would represent 200 shares, and so on.
You sell the call option contract with a strike price of $55 that expires in 30 days.
The option is currently trading at a premium of $2/share, so you receive a total of $200 ($2 x 100 shares).
Here are a few ways this could play out:
The stock price remains below $55 by the expiration date (30 days) and the option expires worthless.
You get to keep the $200 premium and also continue to own the 100 shares of stock ABC.
The stock price rises above $55 before the expiration date and the buyer chooses to exercise the option and buy your shares at the lower price of $55/share.
You still get to keep the $200 premium, but you would sell your shares for a total of $5,500 ($55 x 100 shares) which is below their current market value, whatever that might be.
Now the buyer can turn around and sell those shares for a profit because the market price is higher than what he paid for the shares from you.
Below is a graph illustrating what we just covered (with slightly different strike prices).
Cons of Covered Calls
Covered calls can be a great strategy for generating income for long-term investors, but it would be unwise not to mention some of the potential downsides:
Capping Your Gains: if you’re wrong and the stock price starts to rise significantly, you can miss out on all the additional price appreciation because your shares will get called away at a lower price (the strike price).
Risk of Losing Your Position: if the stock rises above the strike price at the expiration date, you risk losing 100 shares (or more) of one of your positions.
Transaction Costs: every time you sell a covered call, you may need to pay a fee or commission, depending on your broker. These fees can add up over time.
Tax Implications: depending on where you live, generating extra income using this strategy may result in higher taxes, which can also impact your total returns.
Picking Your Spots: writing calls is not a smart idea during the companies earnings season because stocks tend to become very volatile during that period. Stay away from trading options when the stock’s earnings are coming up.
Barrier to Entry: because you need to hold 100 shares of a stock, this may create a barrier to entry for people who don’t have enough capital.