If you were to listen to Warren Buffett, the best way for an ordinary Joe or Jane to invest is to allocate a fixed amount of savings to an index fund each month.
The market ups and downs may make you feel on top of the world sometimes and down in the dumps at other times. But if you can ride the stock market swings without selling any holdings in your lazy portfolio, your regular contributions may produce a handsome nest-egg in the long run.
The passive investing approach is appealing to hands-off investors who are happy with a fixed dividend yield and the upside from rising share prices. But is there a way for investors who want a little extra cash flow to make even more money?
How To Earn Extra Income
From Stocks You Own
Just like an investment property owner who makes money from tenant payments, so too can shareholders earn a regular yield from owning stocks.
And we’re not talking about dividend yield, although that would be a bonus!
To make extra money from stocks you already own, you can do what investing maestros do: sell covered calls.
If you have never bought or sold options before, you may not be familiar with a covered call but it is one of the most powerful stock and options strategies any investor can employ.
Here’s how it works.
Imagine you own shares of a company that have risen in price. You don’t want to sell the shares because they may go higher. But equally you don’t feel especially confident the shares will move much higher.
In this situation, you can sell call options against your shareholding.
The strategy locks you into a simple agreement. If the share price were to rise above a certain price level by a fixed date, you agree to sell your shares at that level.
However, if the share price doesn’t end up above that level by a certain date, you are not obligated to sell your shares.
How To Use Covered Calls
In A Lazy Portfolio
Seems like a bum deal.
Why agree to sell your shares at a fixed price by a certain date?
After all, if you don’t make the agreement, you can continue to make money as the share price goes ever higher.
The short answer is you get paid when you make the agreement. And sometimes, you can pocket a handsome amount.
In fact, selling calls against stocks you own may not lead to a mountain of riches in one month or two, or even three. But over the course of one year, or two or three years, regular income from selling calls can add up to much more than just pocket change.
A short-sighted investor may spurn the idea trading covered calls by enquiring:
“Why make only 0.5% → 1% per month from selling call premiums when I could make 10% this month if the stock rallies higher?”
If the stock were to rally a lot in a short time period, you might indeed be worse off by locking yourself into a deal where you are forced to sell your shares at a lower price point.
But what are the chances the share price will increase by 10% each month?
So rather than evaluate the merits of the strategy over the short-term, it is best to crunch the numbers over the long term.
How Much Can You Make
Trading Covered Calls?
When you calculate the premiums you can earn from selling covered calls against your shares on any given month, they may seem flimsy.
You may not be able to make much more than 0.5% on any given month.
But hang on a moment.
If you could earn 0.5% every month for a year that’s a 6% annual return… which beats the savings rates available at most banks.
Generally, more volatile stocks will pay higher covered call premiums. So, selling call options on a stock like Netflix may offer higher premiums than those on a stock like Microsoft.
Nevertheless, it is usually not a smart idea to buy a stock just for the premium you can earn from selling calls.
After all, if you are looking to sell calls for extra cash flow, you are probably searching for income. And so you may wish to avoid a wild ride of share price gyrations on a volatile stock.
But that’s okay, you may still be able to earn a handsome annual yield selling calls on so-called “boring” blue-chip stocks.
Add in a quarterly dividend payment from these stodgy stalworths and you’re talking about some potentially lucrative cash flow by year’s end.
Now your lazy portfolio can make money from call premiums and dividend payments.
What Covered Calls
Make Most Money?
Selling calls for cash flow requires you to balance greed and fear.
If you agree to sell your shares near their current price point, you will enjoy a higher call premium.
On the other hand, if you are only willing to commit to offloading your shares when the price rises significantly, you will earn a smaller call premium.
Conservative investors may be willing to agree to sell shares at prices closer to the current price so they can lock in higher premiums while risk-seeking investors may be willing to gamble on higher share prices at the expense of lower call premiums.
A financial advisor might be the best person to advise you on which calls to select while a comedian might advise you to sell calls at the price level where fear intersects with greed!
What You Need To Know
Selling Call Options
When you sell call options against your shareholding, you need to pay attention to two big “gotchas” that may otherwise cause your trading strategy to come undone.
The biggest one is to not sell too many calls.
If you own 100 shares of stock, you should generally not sell more than 1 call contract.
Selling more call contracts would mean that you significantly increase your overall risk exposure because 1 options contract usually corresponds to 100 shares.
Just imagine what would happen if you sold lots of calls and your broker informed you that you had to sell stock to meet your obligations.
What would you do?
You would have to buy shares at whatever price they are currently trading at in the market.
And that might be quite a bit higher than the price at which you agreed to sell them, meaning you are buying high and selling lower – never a good strategy!
The second big “gotcha” is forgetting about Uncle Sam.
When your shares are sold, you have to pay capital gains taxes. And if you owned the shares for less than a year, you will pay a higher rate of taxes than if you held your shares for more than a year.
Don’t forget that Uncle Sam will get his share of your gains either way. So, if you have been holding onto your shares for many years, you may want to think twice before selling covered calls.
After all, covered calls are contracts that obligate you to sell shares if the call options are assigned, meaning if the share price rises above the call strike price.
What Brokers Facilitate
Covered Call Selling?
When options trading first became popular, you had to travel far and wide to find a broker who could facilitate inexpensive covered call selling.
These days, you are spoiled for choice because transactions costs are significantly lower than just a decade ago.
Both companies were influenced by renowned options trader, Tom Sosnoff. So, it’s not a surprise that they both have top notch trading platforms and a wealth of features to help make better trading decisions.
And while both are excellent solutions for active options traders, they are equally good for investors with lazy portfolios who don’t want to do anything more than sell calls from time to time against existing shareholdings.
As with any good options broker, tastyworks and thinkorswim are renowned for fast order execution and support teams who understand options strategies well. So, if you want to get adventurous and place more advanced strategies, you won’t stump either broker.
Is Selling Call Options
Right For You?
If you are a hands-off investor who doesn’t want to do any work whatsoever then a robo-advisor like Betterment may be a good place to park your money.
For investors who are willing to log into a brokerage account once in a while, selling calls against a lazy portfolio of stocks or even index funds is a great way to generate some additional monthly cash flow.
If you are not convinced of the merits of the trading strategy, think about a real world analogy where you buy an investment property.
Would you buy the property and not place a tenant in it to help offset the cost of purchasing it?
Of course not, because so doing would mean relying 100% on property appreciation to make money.
Similarly, when you own stock but don’t sell calls you rely primarily on share price appreciation to profit.
Sure, you can make some extra income from dividends. But the amount and frequency of dividends is determined by the company.
By contrast, when you sell call options, the amount and frequency is largely determined by you.
Like a tenant who pays you a rent monthly, covered calls can pay you an income regularly.
Yet unlike an investment property that requires you to maintain a property, collect rent, and find new tenants from time to time, selling calls requires some stock research, a few clicks of your mouse and perhaps a call to your financial advisor.
Where else can you bank hundreds or thousands of dollars a month from an asset you already own – stocks or index funds – with little more than a few clicks?
What Is The Risk Of
Covered Call Trading?
Perhaps one of the worst outcomes when you sell calls against your shareholding occurs when the stock rallies big time and you miss out on share price gains.
But even then you can still earn a profit from both the shares you own and the calls you sell against those shares.
The absolute worst thing that can happen is the stock declines all the way to zero, meaning the company, for all intents and purposes, goes bankrupt.
And even in that situation you end up better off than had you not sold call options against your shareholding because you still get to keep the premium from the calls you sold.
The bottom line is covered call trading is one of the best ways to produce extra cash flow on a lazy portfolio of stocks or index funds.