Today, I want to spend a little bit of time talking about ways to earn more money from your existing stock portfolio.
I know that when it comes to basic leverage strategies and actively managing your portfolio, it might be a little intimidating at first.
Being a buy-and-hold investor is a real path to wealth. Just ask the investors who have followed the strategies of Benjamin Graham and Warren Buffett.
But I want to show you a few ways to take your investing to the next level. In the days ahead, I’ll walk you through three straightforward and conservative strategies to increase your gains.
Again, you don’t have to do any of these. But you must understand the potential of each strategy. (If you have questions, please feel free to send me a note, and I’ll answer them next week).
We’ll start today with one of the most conservative and defensive ways to use options, generate income, and limit your downside risk.
Let’s dive in.
Strategy No. 1: Covered Calls
I want to squeeze every dollar that I can out of a long-term position.
Sometimes, dividends just aren’t enough.
One way you can boost your income is to sell call options on stocks that you already own. Here’s a very simple breakdown of how these options work.
Let’s say that you own 100 shares of Daseke Inc. (DSKE). This company engages in flatbed and other trucking transportation in North America.
On Wednesday, the stock traded at $6.85 per share. That means a position of 100 shares is worth $685. The stock doesn’t pay a dividend.
With these 100 shares, you can use options to increase your income potential. You can “write” or sell a call option that gives the buyer the right – but not the obligation – to purchase your shares at a future date (the expiration date) at a price of your choosing.
Before we dig into this trade, let’s just go over a few simple pieces of terminology that are critical to options trading.
I am going to briefly discuss the Nov. 19, 2021, $7.50 call option.
- Call Option: This option allows a person to purchase 100 shares for every call contract they own. The strike price and expiration date define the contract (see below).
- Strike Price: The strike price is the price at which the options contract can be exercised. In the example today, the strike price would be $7.50. Since we are working with a call option, the stock would need to trade at $7.50 or higher for the buyer of the call option to exercise it.
- Expiration Date: This is the date that the options contract expires. The stock would need to trade at or above $7.50 by the expiration date. If the stock trades at or above that level, the buyer of the call option can exercise it at any time. However, if the price doesn’t reach that strike price by the expiration date, this contract will expire worthless. In that case, the seller of the agreement (you, in our example) would keep the premium and all of their shares.
- Premium: This is the amount of money that the options seller receives from the buyer for the right – but not the obligation – to exercise that contract in the future. The premium is very important because it can provide the seller with additional upside to their position. On Wednesday of this week, the Nov. 19, 2021, $7.50 call option traded for $1.00.
You could sell this call option on your 100 DSKE shares.
You will receive $1 in premium for every share you own (remember, an options contract allows the buying and selling of 100 shares per contract).
Since a contract is 100 shares, you put $100 in your pocket today.
If the stock rises above $7.50 before Nov. 19, the person who buys the call option from you will have the right, but not the obligation, to exercise the contract and secure your 100 shares on or before the expiration date.
Now, why is that $1.00 premium important?
Because even if the buyer of the contract exercises the contract, you get to keep that premium and pocket the additional gains from today’s stock price.
Let’s say, hypothetically, that the stock goes to $8.50 by November and the call buyer executes the contract. You’ll sell the stock for $7.50, but you’ll have made gains in two ways.
- First, you’ll have earned gains from $6.85 to the strike price of $7.50 by selling your shares. That’s $0.65 per share – or $65 total. At $7.50, you will be selling the stock, so your gains here cap at the strike price.
- You’ll also get the additional $1.00 in premium for each of the 100 shares in the contract. That’s $100 in gains per contract.
At that point, you’ve made $1.65 per share – or more than 24% in the 177 days between now and the expiration date. Remember, a covered call “covers” your existing position.
What If the Stock Goes to $10.00?
OK. I know what you’re thinking.
What happens if the stock surges to $10, $20, or $25 in the next few months?
The VQ for this stock is 63%, which means that the stock could rise sharply. Just one VQ deviation would put the stock at $11.17. So, there is a chance this could happen. Let’s talk about this situation.
You could buy back the option that you sold and close that position at a loss. But this is not recommended.
Remember, you are obligated to sell your stock at $7.50 if you write this call option contract. (The only exception is that you can buy the same contract on the market to close your position. If you buy back the same contract with the same strike price and expiration date, you don’t have to sell your stock.)
If the stock rallies, you don’t lose anything. Yes, the person who buys the contract would get to pocket the difference between $7.50 and whatever the price hits on or before the strike date.
But remember – you would have locked in a more than 24% gain if and when the stock reaches $8.50 (remember, you get to keep that $1.00 premium on top of the stock that you’re selling for $7.50 per share). This is your maximum return should the stock continue to rally. But you can’t lose any money in this scenario.
But you could lose money if you sell “naked” calls on the stock.
This means you sell the call option and don’t already own the underlying stock. In this case, you would need to either buy the stock and deliver it or you’ll need to buy back the same contract you have sold. If that stock goes above $8.50 and you have sold a naked call, you will start to lose money.
Comparatively, the covered call is the more conservative strategy that caps your upside to the value of the premium plus the strike price. I don’t know about you, but I’ll gladly take a 24% return on investment, especially in as little as six months.
But, there’s another reason to trade covered calls.
Here’s the Other Benefit
Now, let’s revisit Daseke’s stock.
In my scenario, you buy 100 shares at $6.85 each.
Your position is worth a total of $685.
Let’s say that you sell that same contract.
You get $100 selling a single Nov. 19, 2021, $7.50 call option.
The stock is trading at $6.85 today.
But let’s say that things go sideways for the stock.
Perhaps the stock falls to $6.25 over the next two months.
Well, that $1.00 in premium that you sold can act as a form of protection.
You’ve now protected your stock to the downside at $5.85.
That’s $6.85 minus the $1.00 premium for every share. So, even if the stock drops to $6.00 come Nov. 19, 2021 – the date of the contract’s expiration – you will still have a slight gain in your total position.
Covered calls provide an upside potential toward a specific target to exit in a predetermined time frame. They also offer protection as a hedge in the event that your stocks decline.
This is a very conservative strategy that can be a “win-win” for investors. I’ll talk more about other strategies next week.