In my last post, which you can see here, I covered here the basics of selling covered calls to generate more income than you can receive from dividend yields alone. This post will cover finding the right stocks to select with this strategy, and some pitfalls to avoid. While this strategy is somewhat risk-free, following this guide will avoid some of the most common mistakes.
1) The biggest risk in the covered call strategy is that you actually own the underlying shares.
This risk means that if a stock price plummets, you will feel that pain just like owning any other stock. The difference is that while you are feeling the pain of the price decrease, you are getting the premium from the calls that you have sold, and you are receiving the dividends. But if a stock plummets 25% in a couple of weeks because it missed earnings, the premium and dividends will take quite some time to make you whole.
Therefore, don’t buy a stock strictly because it provides great yield with the covered calls. Evaluate a stock using whatever objective criteria that you use to invest, and make sure that it passes your criteria before you add it to your portfolio.At Chaikin Analytics, we have a 20 factor model that makes this an easy process, but you may have a more familiar method for selecting stocks. Ultimately, you should want to own this stock.
2.) If your stock has appreciated over time, you need to evaluate whether you want to face capital gains if your stock is called away from you.
If you sell a call option, this gives the purchaser of the option (but not the obligation) to purchase your stock at the price set by the strike price. Inevitably, this strategy will trigger some of these events where you stock is sold. Then you will have to pay the capital gains tax on the sale of the stock.
One additional caveat, if you have owned the stock close to a year already. It may be worth waiting for a full year to expire or sell the covered call well after the year’s timeframe. Why? This would allow you to take the gains of the stock sale as a long term capital gain rather than a short term capital gain. Long term capital gains are almost always beneficial because the rate is either 15 or 20% versus the short term rate which is your marginal tax rate.
3.) Look for a stock that has volatility but not too much volatility.
If your stock is a steady-Eddie, the premium for the covered call is reduced. Investors aren’t willing to pay you as much for the right to purchase the stock if it is bouncing along in a flat line without growth. On the other hand, if the stock price swings wildly, you will be able to sell covered calls for a good amount, but you will increase the likelihood that the stock is called away from you. The goal is to “rinse and repeat”. That means sell the calls, have them expire worthless, and then start all over again by selling the calls.
4.) This may be obvious but I will state it anyway. Buy multiples of 100 shares of any stock that you want to employ this strategy with.
Each options contract conveys the right to purchase 100 shares of a stock. So you want to ensure that you actually own the correct number of shares.
As a corollary to this rule. You should set your brokerage account up to NOT reinvest your dividends. Each stock that you own can be set up to either deliver you cash when a dividend is paid or more stock because the dividend is actually reinvested. If you take the stock, you end up getting a number of holdings with just a few shares.
5.) Don’t get overly fixated with large dividend stocks.
While this strategy does benefit with high dividend yields, you will find that you get the larger share of income from selling the covered calls most of the time. Stocks have large dividends for a number of reasons: they have suffered a large drop in price, making their yield grow, they are a safe dividend-paying stock that does not really move in price very often, or they are in the process of reassessing their dividend. None of these work for the covered calls strategy. Rather look for solid stocks in the 2-3% range with decent prospects for growth. Remember, we are looking for stocks that we want to own, not just sell covered calls.
6.) Finally, don’t sell a covered call that expires right after their earnings report date.
Earnings releases often have a short term increase in volatility. This increase typically is not rewarded in your covered call premium. So unbeknownst to you, your risk of having the stock called away has increased without a corresponding increase in premium to you.
While many stocks are good candidates for covered calls, taking a little time to sort through your stocks ensures that you can maximize your returns and your income. The biggest mistake is buying a stock that has shaky underpinnings and drops in value. Other than that, follow these rules and you will soon be growing your income.