Editor’s note:
We’re bringing back a Curzio Classic today, which explains a profitable strategy for volatile markets many investors have never heard of. Learn how to boost your income and add some portfolio protection—on stocks you already own.
Many assets lose value over time.
A new car depreciates as soon as it leaves a dealer’s lot. And as a rule of thumb, a car loses 15-20% of its value annually… until, at some point, it’s worth nothing (the COVID-related used-car rush notwithstanding).
In a similar fashion, an option contract loses value over time. This phenomenon is called “time decay,” and it applies to most option strategies… such as selling puts. That’s because option contracts have a pre-set expiration date. All else equal, the option price will decline… all the way to zero at expiration.
Put-selling is a strategy you can use to purchase stocks at lower prices (my colleague Luke Downey explains how it works here).
A less aggressive version of this strategy we’ve discussed is selling cash-secured puts.
These strategies benefit from the passage of time… and from higher market volatility, as we’re experiencing today.
But in this letter, we’ll talk about another trading method that uses these two factors to your advantage: selling covered calls.
Covered calls, also known as “buy-write,” involve two steps: buying a security and selling (“writing”) call options against it. “Covered” means you already own the shares.
To see how it works, let’s take a quick look at call option basics.
Buying a call option gives you the right, but not the obligation, to purchase a stock at a predetermined price (the “strike” price) by a certain date (the expiration date). One option contract controls 100 shares.
Conversely, when you sell a call option, you take on the obligation to sell a security to a call owner at the strike price by the expiration date.
If you sell a covered call against your existing position, you must have the shares to deliver if the option is called.
On the expiration date, two scenarios are possible:
No. 1: The price of the underlying stock is below the strike price. In this case, the call option contract is worth zero.
No. 2: The price of the underlying stock is above the strike price. In this case, the call option is worth the difference between the stock price and the strike price.
As a call seller, you want door number one.
Ideally, the call you sold will expire worthless. You’d keep the option premium—and won’t need to deliver (sell) your shares. In sum, you benefit from time decay while keeping your stock position.
Let’s say you own 100 shares of ACME, which trades around $200 per share. You see a call option on your shares with a strike of $210 that expires in a month. The option price is $0.75. You decide to sell one contract, generating $75 on your 100 shares.
Our two scenarios:
No. 1: At expiration, ACME is trading below $210 (below the strike price). You get to keep the $75 premium you’ve collected upfront… and your 100 shares of ACME, too. In other words, you’ve made $75 extra on the stock… and can repeat the process if you like.
No. 2: ACME is trading above $210. If that’s the case, you’ll sell your 100 shares at $210—regardless of the current stock price—and keep the $75 premium, too. Your gains on ACME are capped… but you’re not losing money on this trade either.
The ideal stock action for your covered call trade would be for ACME to stay in place, decline slightly, or move moderately higher (as long as ACME trades below $210 at expiration, you’ll get to keep both the premium and the shares).
In fact, even a sharp decline in ACME is OK—as long as you don’t want to sell the stock. You get to keep the premium in either case… which could help weather the decline.
When to use this strategy
Covered call strategies are great for stocks with limited upside… especially if you plan to hold forever.
You might have accumulated a bunch of utilities or telecoms over the years. When you think the near-term upside is limited (but don’t mind selling if shares rally), selling calls on blocks of your shares is an easy way to juice your returns over time.
If they’re called away, you can always buy more when shares decline. Meanwhile, you get to generate extra income from the same positions over and over again.
Covered calls are a good strategy for a flat or meandering market… if you’re moderately bullish on the market or a stock… or expect a slightly declining market.
High volatility also helps, since the risk involved pushes option prices higher—and many call sellers continuously scour the market for promising opportunities.
With covered calls, you trade some of the stock’s potential upside for income. It’s a conservative strategy that can also provide some downside protection for your portfolio… a feature especially valuable when the market’s upside looks limited.
P.S. In my investment advisory, Moneyflow Trader, we use a combination of puts and calls to hedge against any market storm.
If you lost money during the COVID crash, this powerful strategy is for you…
When the market was down 30%-plus, we saw gains as high as 508%… from a single trade. And during the recent volatility, we’ve seen quick gains like 103%… 124%… and 240%.
Frank and I predict a volatile 2022 will hit many portfolios hard… so please, make sure you’re protected.
