Earn 15%-20% with This Safe Income Strategy
By Jeff Clark
June 19, 2007
Let's face it, traditional approaches to income aren't really working right now.
Oh sure, you can sit in a money market fund and get 4.5% or even 5%. That's safe. But after taxes and inflation, you're barely ahead of the game.
You can boost your yield with long-dated or low-quality bonds. You can buy a real estate investment trust or maybe pick up a utility stock or two. But none of these ideas has held up very well over the past few weeks of rising interest rates.
The fact is that only one income-producing idea really offers high returns and low risks when interest rates are rising: covered call writing.
Although covered call writing involves the use of options, it actually is quite simple. When you write a covered call, you buy a stock and then sell someone else the right to buy it from you in the future.
That's it.
Think of it in terms of real estate…
Let's say you buy a piece of property for $200,000. You then turn around and sell someone the right to buy it from you anytime in the next three months for $210,000. For that right, you charge a premium of 4%, or $8,000.
You pocket the $8,000 immediately. It's your money now. You also are obligated to sell the property for $210,000 if the buyer chooses to exercise his right.
There are three possible outcomes to this scenario…
- The property goes up in value, and the buyer exercises his right to buy. In this case, you've pocketed the $8,000 premium, and you'll be selling the property for $210,000. Here, you'll have an $18,000 gain (9%) in three months, and you'll have to find another investment property to buy in order to continue the strategy.
- The property remains worth $200,000. In this case, you keep the $8,000 premium. And, since the buyer won't be willing to pay $210,000 for a property that's only worth $200,000, you'll keep the property too. You've made 4% over three months. And since the buyer's right has expired, you can sell the right to someone else for another three months, thereby repeating the process.
- The property falls in value. In this case, the $8,000 premium you received helps to offset the loss on the property. The buyer walks away when the right expires, and you're free to sell another right for another time period.
So if the investment goes up, then we sell it for a gain. If the investment stays the same, then we profit off of the premium. And if the investment drops in value, then the premium helps offset the loss.
I know it sounds like a terrific strategy, but there are two major pitfalls…
First of all, if a stock drops 10%-20%, you can make up for the loss by selling premium a few times. But if the investment collapses, the small premium you received by selling the option won't do much to alleviate the loss on your "safe" money. So you have to make sure that your investments are absolute bargains.
Unfortunately, a lot of people who try selling covered calls get sucked into buying expensive stocks because the call premiums are quite large and the theoretical returns can be huge. But that strategy carries a lot of risk, and it's not a good place for safe money. The bottom line? Only sell covered calls on safe, cheap stocks.
The other pitfall to covered call writing is that you sell off your potential for enormous gains.
Take our previous property investment for example. We are obligated to sell the property for $210,000. That's a good gain, especially considering the extra $8,000 premium. But if the property jumps to $300,000, then we'll be kicking ourselves for selling at such a cheap price.
If you like the prospects of a stock and believe it could easily double or triple, then you shouldn't sell options against it. All you're doing is capping your profit potential and guaranteeing that you'll be out of the trade before it explodes higher.
To put it another way, you should only write calls against stocks that you wouldn't mind selling at the agreed-upon price. And, if it moves higher after you're out, then who cares? You met your objective and moved on.
The purpose of covered call writing is to generate income, not capital gains. It's the difference between buying a bond and buying a stock. Stock buyers look for capital gains. Income is secondary. Bond buyers want the income, and any gains are a bonus.
Folks who write covered calls are bond buyers.
So if you're objective is to generate 15%-20% per year in income off of a safe portfolio of stocks, then covered call writing is an ideal strategy.
Best regards and good trading,
Jeff Clark
