The risk here is that shares might jump to $100. In that case you’re “stuck” selling at $95 when you could have simply held on to the shares and had a higher level of wealth. You might be kicking yourself in this scenario for having spent extra time thinking about how to “cap” your potential gain.
Yet I would contend that this is why you need to be happy with either side of the agreement. In this scenario your total return would be between 17.5% and 20.5% in less than 10 months. While it could be lower than what actually happens, it’s not exactly a great tragedy either. If you could consistently earn this type of return you’d be on the fast track to substantial wealth creation.
This is why covered calls can be attractive. If you wouldn’t be happy selling at any price, then naturally these sorts of agreements are not for you. Yet if you’re looking for a bit of additional income, there are many options out there (literally) that can help to supplement your cash flow goals.
In this particular case you would either bump up your yield from 2.75% to 4%, or else see a total return in the 18% to 21% range in less than a year. If you’re happy to hold shares in the first place, both scenarios appear quite reasonable in my view.
And naturally there are numerous other possibilities. This is just to give you an idea of the process. You can adjust the expiration date and strike price as you see fit. Perhaps you’d be happy to sell at $85, in which case your upfront income would be higher. Or perchance you’d like to make a shorter time commitment, as many investors do. The concept is that there is a great deal of flexibility associated with using options (they’re aptly named).
To conclude this introduction, I’d like to go over some basic benefits and downsides associated with selling covered calls. Let’s start with the good stuff.
Option Benefit #1: More Income
This one is obvious, but also the largest benefit. An agreement to sell at a certain price without a premium isn’t call an option, it’s called a limit order.
The benefit of selling a covered call is that you receive upfront cash flow once the agreement is made. That’s yours to keep. Regardless of whether the option is exercised or not, regardless if the share price goes up 20% or down 20%, you receive immediate cash flow.
In the above example the added benefit is just over a 1%, but this amount can be much high depending upon the security, time frame and strike price.
Option Benefit #2: You Can Reinvest Right Away
Unlike dividend payments which come in quarterly installments, you receive the option premium the moment you make the agreement. That’s money available to you to that you can do whatever you choose. Time is on your side with those funds, as you’re able to reinvest right away.
Option Benefit #3: The Downside Is Mitigated
If the option is not exercised, selling a covered call is always going to provide a higher return. In the above example for any share price between $0 and $95, you would have been better off because you would be ~$1.10 per share ahead of the “normal” situation of just holding.
That doesn’t mean that your return must be positive, but it does indicate that any downside is mitigated and any upside (up to a $95 share price) is boosted.
Option Benefit #4: Allows You To Own Lower Yielding Securities
A lot of investors have minimum yield requirements when searching for a security. This makes sense if you need a certain amount of cash flow.
Yet it doesn’t have to be entirely driven by dividends. Instead, you can look for the best businesses and then see what types of agreements are out there to supplement your dividend income. For that matter, a security doesn’t even have to pay a dividend for you to be able to derive cash flow from owning it.
Those are the basic benefits, all of which stem from the premium you receive for making an agreement to sell at a price that you would be happy with.
