dennis mccain
  • Home
  • Investing
    • Dividend Kings
    • Div Aristocrats
    • Div Champions
    • Business Dev Cos
    • Monthly Dividends
  • Options
    • Weekly Options

Investing

Ideas and Strategies on Investing.

Previous Articles

A Simple Options Strategy

5/7/2014

0 Comments

 
If you’ve ever considered an options strategy as part of your overall investing strategy, here’s a relatively simple trade that I often execute to supplement the monthly and quarterly income I receive from dividends on stock that I already own. It’s a simple strategy but it’s one that’s a two edge sword. It can reduce your initial investment but it does this by limiting your upside potential. That may not sound appealing to new investors because most of them emphasize only the potential gain that can be achieved. But a smart investor, an experienced investor, always looks to reduce the risk involved in any trade he enters into. 
Picture
This simple options strategy is a strategy that’s less risky than simply buying and holding stocks for lengthly periods of time (often referred to as the pay and pray strategy). So if this simple options strategy type of investing interests you, you might want to consider selling covered calls like I do. As long as you’re aware of the potential risks (including transaction costs and tax and wash sale implications) this basic strategy is designed to help generate additional income from stocks you already own.


What is a Covered Call?
As you may already know, there are two types of options: call options and put options. In both cases an investor can be either long or short each of these option types. These options can also be either covered or naked. And while many advanced option strategies have exotic sounding names, every option strategy is based on the simple idea of the buying and selling of call and put options. 
Picture
A detailed explanation of each of the advanced option types, along with the many strategies and tactics of using each of these options types, is way beyond the scope of this article. If interested in learning about these, information can be found at many websites around the internet. For those looking for an actual book to read, I learned most of what I know from the book "Options As A Strategic Investment" by Lawrence G. McMillan. This is an excellent and comprehensive book on every aspect of options trading.

For simplicity sake here is a working definition of who a call and put option buyer is. A Call Option Buyer is the buyer of a call who has the right to buy the underlying stock at a set price until the option contract expires. A Put Option Buyer is the buyer of a put who has the right to sell the underlying stock at a set price until the contract expires.

Selling a Covered Call, also referred to as writing a call, can only occur if you already own shares of the underlying stock and you sell another investor, a Call Option Buyer, the right, but not the obligation, to buy that stock at a set price until the option expires. The obvious question is, “Why would anyone want to sell their rights to their stock?” And the answer is "Any investor who wants to receive cash (the premium) that will reduce his initial investment in the security". If this activity is repeated several times and if, over time, a sufficient number of options are sold, the initial cost of the underlying security will eventually be reduced to zero.

For the uninitiated investor the idea of receiving extra income (in addition to dividends) on stocks they already own sounds too good to be true but like any options strategy there are risks as well as benefits. The intent of the options seller is to reduce those risks and enhance those benefits.


How this strategy works
Before making any trades, it’s critical to understand how this strategy works. For example, suppose an investor owns 100 shares of company "AAA" currently selling for $30 per share and he decides to sell (or write) one call (one call is equal to 100 shares of stock). The investor is contractually agreeing to sell those 100 shares for an agreed upon price known as the strike price. The premium that the investor receives is determined by a bid and ask price model but for a given stock, the higher the strike price is above the stock price, the smaller the premium is. In addition, premiums are larger for expiration dates that are farther out than for dates that are closer in. For example, an investor who chooses an expiration date three months out, the option will have a larger premium than one with an expiration date of only one month out. Luckily, for most securities there are multiple strike prices and multiple expiration dates so there's a myriad of choices for the option seller.

Let’s say in January an investor chooses to sell a covered call with a February expiration date. On the third Friday of the month trading on that option ends and on the following day it expires. At that point either the option is assigned and the stock is sold at the strike price or the seller keeps the stock. If, at the time of expiration, the price of the stock remains below the strike price the option will expire worthless and the covered call writer keeps all the money. He then has the option to sell another covered call.

This sounds simple and it is for more experienced investors. For new investors, however, it takes a little experience to find the right strike prices and expiration dates that work best for the security he's holding. New option sellers may want to initially experiment with one option contract and with different strike prices and expiration dates until they find that right combination that works for them.

I have found over the years that owning good quality stocks that allow me to sell covered calls against them can generate a series of premiums equal to, and sometimes greater than, the underlying stock’s dividend distribution. And in many cases I can double that dividend. And that's a dividend growth investor's dream.

This may just be one strategy that's worth taking the time to learn.

Good Luck and Good Trading.

Picture
0 Comments



Leave a Reply.

    Print Friendly Version of this pagePrint Get a PDF version of this webpagePDF

    Picture

    Author

    I am an Individual Investor with specific interest in long term growth and then enhancing my returns with income from dividends and derivatives. I don't recommend stocks to anyone (it's a good way to lose friends) and no one reading this should misinterpret my blog as a recommendation for any type of investment. I am writing this solely for myself and my kids.


    RSS Feed


    Picture
    Top 100 Blogs for Dividend Investors

    Picture
    Follow Me on StockTwits!



    Dividend Growth Stocks
    Dividend Growth Investor


    Picture
    I'm on Seeking Alpha too!

    Archives

    August 2018
    July 2018
    June 2018
    May 2018
    April 2018
    March 2018
    February 2018
    January 2018
    December 2017
    November 2017
    October 2017
    September 2017
    August 2017
    July 2017
    June 2017
    May 2017
    April 2017
    March 2017
    February 2017
    January 2017
    December 2016
    November 2016
    October 2016
    September 2016
    August 2016
    July 2016
    June 2016
    May 2016
    April 2016
    March 2016
    February 2016
    January 2016
    December 2015
    November 2015
    October 2015
    September 2015
    August 2015
    July 2015
    June 2015
    May 2015
    April 2015
    March 2015
    February 2015
    January 2015
    December 2014
    November 2014
    October 2014
    September 2014
    August 2014
    July 2014
    June 2014
    May 2014
    April 2014
    March 2014
    February 2014
    January 2014
    December 2013
    November 2013
    October 2013
    September 2013
    August 2013


    ADDITIONAL RESOURCES:
    4 Month INDU Chart
    Dividend Ex-Dates
    Bidness Etc
    SharpCharts Voyeur
    StockCharts.com

    FINVIZ
    Seeking Alpha
    BDC Reporter
    Roadmap2Retire
    DivHut
    Dividend Growth Investor

    Dividend Yield

    Stock Market Mentor
    Chart Swing Trader
    Dividend Announcements
    IBD TV
    Stocks to Watch Today
    Dividend Detective

    DISCLAIMER
     I am not a licensed investment adviser, and I am not providing investment advise for you on this site. Please consult with an investment professional before you invest your money. Any opinion expressed here should not be treated as investment advice. I am not liable for any losses suffered by any party because of data or information published on this blog. Past performance is not a guarantee of future performance. Unless your investments are FDIC insured, they may decline in value.

    Picture
Powered by Create your own unique website with customizable templates.