Posted by Leo T. Ly on August 17, 2018August 16, 2018
Last week, I wrote the first part of a three-part series to explore new opportunities to generate more passive incomes with options. The first part covered the basics about options and addressed many fundamental questions to provide my readers with the required background for the next two posts. In this post, I will be exploring and providing more in-depth coverage on how to increase your passive income by selling covered call options.
Why Am I Selling Covered Call Options?
To me, if you are trading options, you are participating in a form of gambling. I consider the investors that purchase the options the gamblers because they are betting on the directions of the stocks. The investors that are selling the options are the houses because they get to set the terms and conditions that can work to their advantage.
When you can legally tilt the odds of any transactions in your favour, it’ll increase your chances of being successful. By selling covered call options, I think I’ve found a couple of ways to increase my investment success, which in turn, increases my passive income. And that’s exactly my purpose for selling covered call options rather than buying them.
What Factors To Consider When Selling Covered Call Options?
The first factor to consider is the time value of the options contract. The longer the time to expiration, the more premium the purchaser needs to pay. Also, as time goes by, the value of the option decays, which means time is working for you (the seller) instead of against you (the purchaser). Hence, I use this factor towards my advantage by selling options contracts that are between six and fifteen months in duration.
One of the reasons that I set this contract duration is to maximize the premium that I collect. Another reason is to provide the flexibility to make adjustments when there is market news that affects the stock. Third, I want to minimize the number of contracts that I write to lower my trading costs.
The second factor to consider is the current price of the stock. When selling covered call options, I not only consider the amount of premium that I collect, I also consider the overall return of this transaction. If the purchaser of my options decided to exercise it, I want to ensure that my annualized return (capital gain + dividend + premium) for this transaction is at least 12% or more.
The third factor to consider is volatility. It can either be the volatility of the underlying stock or the stock market itself. Either one will provide you with an increased premium.
When Is A Good Time For Selling Covered Call Options?
To increase my chances of investment success (make more money), I timed the market when selling covered call options. I usually pick a time when the stock is trading near or at its 52 weeks or all-time high to sell. This way, I can ensure that I have some capital gain factored in and will be adding more gains on top if my options get exercised.
What Is Best The Strategy For Setting The Strike Price?
I rarely set the strike price of my covered call options within 5% of the current market price. As I mentioned, for any of my covered call options contracts, I want to earn at least a 12% annualized return. This means that the strike price is often set at 8% or higher than the market price. The premium received will normally be 2% or higher and the dividends can be 0% or higher. Overall, the combined value of the capital gain, premium, and dividends for my covered call option trades provide at least a 12% annualized return.
Selling Covered Call Options Just To Earn The Premium
When selling covered call options, I have no issues and don’t have any regrets if my options get exercised. I know that I will at least make a decent profit. However, sometimes, I don’t always want to sell my stock when selling covered call options. I just want to earn the premium. If this is the case, I set the strike price a lot higher than the current market price.
For example, when I first bought 100 Shares of Chipotle Mexican Grill (CMG) at $430/share back in 2016, I sold one covered call contract with a strike price of $600/share. The expiration date for the contract was January 2018 and I was able to collect about $16/share or $1,600 in premium. Based on this contract, the premium was about 3.7% of the market price. I am more than happy to sell it at a strike price of $600/share and make a 40% return in just a bit over a year’s time. However, if the stock never reached that strike price, I am also happy to keep the premium for free.
I often use this strategy to earn more income from the growth stocks that I own. This means, that the underlying stock may pay little to no dividends, has high revenue/income growth and high volatility in the stock price.
Selling Covered Call Options To Increase Capital Gains
From time to time, there may be a stock that I want to sell. However, I don’t want to sell at the current market price, I want to sell it at a higher price. To do this, I sell a covered call option with the strike price that’s just slightly above the current market price.
For example, earlier this year, I sold seven covered call contracts for Extra Space Storage (EXR) with a strike price of $85/share. The expiration date for the contract is September 2018 and I was able to collect about $5/share (or $3,500) in premium. Based on this contract, the premium was about 5.9% of the market price.
Since I want to sell EXR anyway, I am content to earn about 7.7% more (5.9% premium + 1.8% dividends) if my options get exercised. However, if the stock price drops below $85/share, I am also happy to keep the premium and collect my dividends.
How Often Does My Covered Call Options Get Exercised?
When the market price of the underlying stock moves above the strike price, it’s very likely that the purchaser o my covered call options will exercise the right to purchase the underlying stock from me. Some of you may wonder, how often does my covered call options get exercised using my strategy? After reviewing the last ten years of my covered call transaction history, it came to about 12%. In another word, about 1 out of every 8 of the covered call options that I sold, got exercised.
| Options – Contracts | Ticker | Expiry Date | Strike Price | Market Price | Premium | Status |
|---|---|---|---|---|---|---|
| Covered Call – 2 | CNR | January 18, 2019 | $120.00 | $116.21 | $240.00 | Active |
| Covered Call – 4 | SNC | December 21 18, 2018 | $62.00 | $53.31 | $540.00 | Active |
| Covered Call – 7 | SLF | January 18, 2019 | $58.00 | $52.90 | $693.00 | Active |
| Covered Call – 5 | TCK.B | January 18, 2019 | $43.60 | $29.51 | $1.985.00 | Active |
| Total Premium: | $3,458.00 | |||||
Table #1: Canadian Covered Call Options contracts sold in 2018.
Passive Income Generated By Selling Covered Call Options In 2018
Table #1 lists the covered call options that I had sold so far in 2018 from my Canadian stocks portfolio. Currently, all the covered call options are out of the money, meaning the market price is lower than the strike price. At this rate, I will be keeping all the $3,458 in premiums for free.
| Options – Contracts | Ticker | Expiry Date | Strike Price | Market Price | Premium | Status |
|---|---|---|---|---|---|---|
| Covered Call – 13 | BB | January 18, 2019 | $15.00 | $10.08 | $715.00 | Active |
| Covered Call – 2 | CMG | January 18, 2019 | $480.00 | $502.70 | $1,488.00 | Active |
| Covered Call – 7 | EXR | September 20, 2018 | $85.00 | $94.27 | $3,500.00 | Active |
| Covered Call – 8 | PKX | November 16, 2018 | $95.00 | $69.66 | $3,580.00 | Active |
| Covered Call – 5 | WFC | January 18, 2019 | $75.00 | $58.66 | $860.00 | Cancelled |
| Total Premium: | $10,143.00 | |||||
Table #2: U.S. Covered Call Options contracts sold in 2018.
Table #2 lists the covered call options that I had sold so far in 2018 from my U.S. stocks portfolio earning a total of $10,143 (USD) in premiums. Currently, three of the covered call options are out of the money and two (CMG and EXR) are in the money, meaning the market price is higher than the strike price. For the two in the money options, I will most likely have to sell my stocks if those stock prices don’t come down.
For EXR, if I have to sell it, my return will be about 15% when I include the capital gain, premiums, and dividends. For my CMG options, if it’s exercised, I’ll make a handsome profit of about $110/share (capital gain plus premiums) as my average cost per share was about $377/share. For these two options, I may have limited my gains, but I am content with the potential profits.
Selling Covered Call Options For A Living
For the past few years, the premiums that I earned ranged from about 1% to 2% of my total portfolio. With a current stock portfolio worth around $1.2M, generating $10,000 or more per year in options premiums is not very difficult. The premiums earned has been consistently growing with the size of my portfolio. Hence, selling covered call options for a living seems more and more viable as I get closer and closer to achieving financial independence.
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The Risks Associated With Selling Covered Call Options
With any types of investments, there is always some sort of associated risks. And covered call options are no exceptions either. One of the risks of selling covered call options is that you have to hold on to the stock and can’t sell it even if it dropped significantly.
To mitigate the risk of significant loss, there are a few measures that one can take to minimize one’s lost. The first measure is to choose stocks with a strong track record of increasing their dividends and earnings that can easily cover their dividend payments. These ways, even if the stock price experiences a significant fall, you’ll still get your dividend to wait for the stock price to recover.
When a stock’s price falls, usually, the price of the call option will fall along with it too. If you want to limit your losses, you can always close your covered call options by buying the same number of contracts. Once your covered call options are canceled, you are free to sell the underlying stock.
Limitations Of Covered Call Options
One of the limitations of covered call options is the cap on your gains on the stock. Sometimes, even with a stable stock like McDonald’s (MCD), it can increase significantly within a year. In this case, you are giving up all the potential profits above the strike price.
For example, McDonald’s stock price increased from $127/share at the beginning of 2017 to $172/share by the end of 2017. I sold four options contracts with a strike price of $140/share expiring January 2018. As a result, I had to sell my 400 shares of McDonald’s at $140/share and missed out on quite a bit of gain. Most of the time, I’ll win in my options transactions, but this time I lost out on some potential gains. However, I still made a decent profit from this stock.
My Two Cents
To earn more passive income, you may not have to invest more money or take additional risks. If you have a great portfolio of stocks, you can increase your passive income and investment returns by selling covered call options. With any types of investments, it’s best that one does the required research to understand what one is investing in. Only invest in what one fully understands and not taking more risks than one can accept.
So readers, do you currently own a portfolio of individual stocks? If you do own individual stocks, would you consider selling covered call options to increase your passive income and returns?
