So you’ve got a handle on finding stocks that you want to own. You’ve made a few picks that you want to own for a long time. Now the question is, how can you own your stock and get paid too? Some stocks offer dividends which can be paid out either annually, semi-annually, quarterly or monthly. Most the time, these dividends are paltry in comparison to the cost of the stock. So how can we utilize our positions to increase cash flow? Covered calls are the hidden weapon that allow you to get paid. Follow the steps below to begin getting paid to own your stocks.
1. Add the ‘Optionable’ Option to Your Stock Screener
You already have a system that is working for picking stocks. You just need to make a slight tweak. When you add the ‘Optionable’ screener to your stock screener then you will only see stocks that also have tradeable options. Without this, you will not be able to write covered calls and create an income from owning your stocks. I also personally look for stocks that are already paying dividends. Along with your other criteria for owning stocks, you are now going to look for a position that you are willing to own. It is important to take a look at the next step when considering the price range on your stock screener as well.
2. Purchase 100 Shares of the Stock
You are going to need 100 shares in order to do a covered call. When you write a covered call you are giving someone the right, but not the obligation to purchase 100 shares of that stock at the strike price entered. This is why you need to have a 100 shares on hand at your brokerage in case the option gets exercised. This is also why it is important to look at the prices of the stocks before hand too. It is a lot easier to buy 100 shares of $T then it is to buy 100 shares of $BRK-A (although you can’t do options on $BRK-A). If you are looking for a better way to enter this position besides a limit buy, I suggest you check out our post on getting paid for your stock watch list.
3. Choose an Expiration Date
This is the date that is ‘do or die’ for your options contract. Depending on your goal for the trade, it could be good or bad if the contract expires worthless. Assuming we are using this position strictly for generating premium, we are hoping the contract expires worthless OTM, or out of the money. This means you get the keep the premium you receive for contract as well as keeping your stock.
When choosing an expiration date, we want something that is far enough out that we are still receiving premium. We also don’t want an expiration date that is too far out causing a higher probability of our stock being called away. Some other things to pay attention to when choosing expiration dates are earnings calls, ex-dividend dates or even mergers and acquisitions. Any of these things can cause unpredictable swings in the stock price. I typically like to use 30-45 days as my range for expiration dates. Long enough to capture time decay but also remain relatively predictable.
4. Choose a Strike Price
Here is where you can really make or break your trade. Choosing a strike price. You want to look for a strike price that is going to give enough premium to make the trade worthwhile. You also don’t want to go too close to the current price, otherwise your contract may be exercised. I simply go and look at my entry point for the position and determine what I would be willing to sell the stock for.
Let’s say I used my cash-secured put strategy to reduce my cost basis. I am able to get a $30 stock for a cost basis of $29. Now lets say I am willing to let the stock go for a 20% gain. That means I need to sell it at $34.8 However, if I use a strike price of $34 I am able to collect $0.8 premium as well. So I choose the strike price of $34. Now obviously these numbers are made up and over simplified but you get the point.
5. Write A Covered Call
Your next step is to write the covered call! You did all the heavy lifting now it is time to get paid. To do this you will simply ‘sell to open’ using your strike price and expiration date. The number of contracts is based on the amount in hundreds of shares you own. It is important to look here at the spread between bid and ask. Bid is what people are willing to pay for the option. Ask is others are willing to sell the option for. The price that you see on most brokerages is the average between the two. For securities with less volume, the difference between the bid and ask can be quite large. I would try to utilize a limit sell for the premium you are willing to receive. Congratulations you now own your stock and get paid for it too!
6. Monitor Your Position (BONUS)
This one is an extra step but can really increase your profit and even turn losing positions into winners. It is to actively monitor your contracts and the underlying securities. OTM calls are directly correlated with stock price. So if a contract is nearing expiration and has declined in value, it may better to roll your position. This involves ‘buying to close’ your current position. This will be at a lower premium due to the decline in stock value as well as the shorter time to expiration. The next step is to ‘sell to open’ a new contract at a later expiration date. This can be at the same or different strike price depending on your strategy. Either way you should receive a net positive in premium for rolling.
The other scenario is when the underlying security either has met your strike price or exceeded it. Now you have two options. You can accept that your stock will be called away and you will receive the money for that. Or you can again ‘buy to close’ the position but this time for a higher premium. The higher premium can be offset by writing a new contract with a new expiration date and strike price, but often times it is not completely covered. This is why it is vital to monitor your positions on a regular basis.
Own Your Stock and Get Paid For It
As long as you follow the steps above you can begin writing covered calls and getting paid for your long positions. These strategies can be useful no matter what the overall market is doing. You are still generating cash flow while taking advantage of the upside. The only downside of this strategy is you limit your growth on the individual security unless you roll your position. It is also important to manage your trade and your risk management strategy. Keep these key reminders at the forefront of your mind and you can own your stock and get paid for it.
Do you use covered calls regularly? Let me know what securities you are following in the comments below!