Five call-option strategies to turn stocks into income-producing machines
Many investors use call options to enhance their investment income. This can be a very good strategy, particularly in volatile, sideways markets like the one we are currently experiencing.
Selling options against existing positions boosts your overall return, and provides a bit of protection (but not much) in a declining market. We will not cover the basics of call-writing strategies, but here are five strategies to consider if following this approach.
Use stocks you would be comfortable owning
This is perhaps the key thing to remember. Many option writers see high premiums on certain volatile stocks (usually in the technology or biotech sectors), and buy companies they are not familiar with and then sell options on them. They then find the volatility of the stocks a little too much to take.
Remember that call writing is an incomegenerating strategy, not a strategy to add even more stress to your investment life. Stick with companies that you would be happy to own anyway.
Keep the basics in mind, and do not reach for returns by buying smaller, more speculative positions.
Sell options on stocks that pay a dividend
Since call writing is designed to boost your income, selling options on companies that pay dividends can potentially boost it even more.
If you are selling options on a regular basis, every three months, those positions that have not been called away will pay you a dividend. It is a nice little bonus in an income-enhancing plan.
For example, Apple Inc. might be an ideal candidate for an option strategy. It yields 1.8 per cent if your stock does not get called away.
But because Apple is a volatile stock (but large and safe, with US$200 billion in cash), you can earn about two per cent more per month from at-the-money call option premiums.
Suddenly, a relatively secure blue-chip stock turns into an income machine.
Target companies with lots of cash, little debt
Another key to an options strategy is to limit your downside risk, and what better way to do that than to use companies that have no debt and lots of excess cash?
Cisco Systems Inc., for example, has US$35 billion in net excess cash, representing about one-quarter of its market value. Still, slightly above the money call options can return about 4.3 per cent in 45 days if exercised.
The cash should provide a cushion in a down market, allowing you to continue selling calls if your position is not called away.
Choose stocks with plenty of volatility
Options premiums depend on volatility: The more volatile the stock, the higher the premium on options.
As mentioned, many small and mid-cap stocks are very volatile, but we do not suggest using a call-writing-income strategy on these.
Instead, find large companies with stocks that are exceptionally volatile, such as Netflix Inc. Its market cap is US$45 billion, but its stock moves like a yo-yo.
Since Netflix reports earnings on Oct. 14, premiums have spiked. At the time of writing this, a nine-day in-the-money call option nets you an eight-per-cent return.
The company could miss estimates and fall sharply, but you at least have an eight-per-cent cushion on the drop, and you can always sell more options if that occurs.
Only use short-term options
This is the second-most important point behind owning companies you are comfortable with.
You can get options premiums on some companies of three or four per cent or more in a very short period. Some stocks will swing wildly, of course, but stocks on average do not move that much in a month.
We have found that using one-month options works best.
If you set up a diversified portfolio, most of the time you will just collect premiums, which will enhance your income.
In a rising market, you will get called away more often, but, hey, it’s a rising market and your portfolio is still going to be doing fine.
Most investors find options confusing, but they really are not. And the possibility of significantly enhanced income makes it worthwhile for investors to at least understand the opportunity that exists.