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How to Get a 40% Annual Yield for Monthly Income

As income investors, we are constantly seeking investments to secure income for our portfolios. The majority seek dividend through income stocks. At Get Rich Investments, we suggest a healthy dose of stocks that pay monthly dividends. In such a low yield world, these investments offering monthly dividends can prove to diversify your income opportunities. There is also an opportunity to earn a high call yield to produce a significant amount of monthly income.

What is call yield and how does it differ from a dividend yield. In typical income investing, an investor may purchase a stock that pays an annual dividend such as a 3-5% yield. In comparison, the income investor may enter a trade using a covered call strategy. This trade is based on the investor owning 100 shares of stock for each call option sold. The investor receives a premium (income) for each option sold against their stock. The premium income forms the call yield based on the premium divided by the cost of stock.

Let’s look at an example subscribers to our Monthly Income Newsletter invested in during 2019. The stock was Starbucks Coffee (SBUX) that was purchased in January 2019 at $61.30 per share. The total investment for 100 shares would have cost the investor $6,130; and is the denominator of the call yield. Then, each month January through November expiration a front month call option was sold for income. The total amount of call premium income during this period is $2,350 or $214 per month. To calculate the call yield, you divided the $2,350 in call premium by the total cost ($6,130) for 38.3%!

Now hold the farm, this strategy created a 38% call yield! Where can you achieve this amount of dividend yield in such a low yield market without something like a startup-type risk?

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In comparison, if you were just a stockholder you would have received $144 in dividends for a 2.3% dividend yield. By using the covered call strategy, you achieved a 40.6% yield combining the call yield (38.3%) and the dividend yield (2.3%). You should keep in mind this is over 11 months of a covered call strategy.

As a covered call investor, you can place this type of trade on most stocks in the market. I suggest focusing on blue chip type of stocks. Subscribers are engaged with around 10 of these trades and also trade other covered calls on a monthly basis.

There are additional benefits to using this strategy beyond the high call yield. Recently, SBUX was trading at $86.00 per share that created a capital appreciation of a little over $2,400 for this investment.

The covered call strategy creates some downside protection if the stock price has a temporary pull back based on market trading.

In conclusion, income investors should add the covered call strategy to their portfolio to supplement other income investments. It is prudent to not only create multiple streams of income but also diversify your investing strategies across your total portfolio. If low yield have you down, look to a consistent covered call strategy to create a high call yield. Here’s to the next 40% or better income yield.

Understanding Option Premiums for Income

Option Premiums

The premium is the price paid or received for an option. Options are traded much like stocks, with bid and ask prices shown:

  • Seller generally receives the bid price
  • Buyer generally pays the asked price

 

  • Market maker makes or specialist keeps the spread between the bid and ask prices.

An example: A stock is trading at $40, and the October Call prices are quoted as follows:

BID = $1.70 ASK = $1.80

This means the high bidder will pay $1.70 and the lowest price offered to the buyer is $1.80. Note the $0.10 spread between the two prices. Actually, the only time the seller can be assured of getting the bid price, or the buyer only the asked price, is to enter a trade order as a market order, at which they get the market price at the time the order is executed. Market makers have to execute a market order at market price, up to the number of contracts for which the bid or offer is good, but are not obligated to take limit orders. By using the limit order, the seller might get the $1.75 or $1.80 for writing the call. And the buyer can enter a limit order for less than $1.80 such as $1.70 in an attempt to buy the call at a cheaper price.

Historically, the premium referred to the total amount received for selling the contract, not to the option price. Today the term “premium” simply means the options price on a per share basis. That is, the premium shown is bid at $1.70 that means $1.70 per share; you would expect to receive $170 ($1.70 X 100) for an entire option contract related to 100 shares. The premium can be all intrinsic value, all time value or contain both.

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Understanding Option Exercise and Assignment

Exercise and Assignment

When a stock option is exercised, the call holder buys the stock, and the put holder sells the stock. When options are exercised, the OCC decides to which brokerage firm the exercise will be assigned, and the brokerage in turn decides which customer will get the assignment. When we are assigned an exercise and are required to sell our shares, the shares sold are said to have been called out or called away. Assignment occurs, then the shares are called out. Assignment on a short puts means purchasing the stock.

Assignment is completely random, and an exercise can be assigned to and appointed among several different call writers. Once assignment by OCC occurs, settlement between the buying and selling parties is automatic. Shares must be physically delivered once exercise occurs. The covered call writer doesn’t have to do anything; the call writer’s broker handles settlement, delivers the shares and collects the exercise funds. Option exercise or assignment can be partial: one can exercise less than all options held. Conversely, you may be assigned on less than all of your short calls or puts. However, one cannot exercise or be assigned on part of a single option contract. If you buy a call (put), you are not required to buy (sell) the underlying stock: you may sell the option to close or allow it to expire worthless.

Automatic Exercise

The OCC automatically exercises options that are $0.01 or more ITM, unless the option holder has notified their broker not to allow exercise of the option. Note that a stock’s price can tick up or down after the close on expiration Friday, resulting in calls or puts (but not both calls and puts) that were near the money at Friday’s close becoming in the money – and being exercised.

If you are long calls on expiration Friday, you could find yourself purchasing shares unexpectedly, due to a late-day or after market tick up in the stock. Or if instead long the puts, then, you might find yourself selling shares unexpectedly: and if you don’t own the underlying shares, this would either create a short stock position in your account, or your broker would buy you in (purchase the shares on your behalf) in order to cover itself. Be sure your broker knows your intention if you are long options at expiration and have nor closed them. Writers of short calls and puts can similarly find themselves assigned an exercise due to the same mechanism.

Early Exercise

Because stock options are American-style, you can be assigned as exercise any time an option is in the money, although options typically are not exercised early while there is still time value remaining. The reason is that the exercise of an option forfeits its time value; to capture the time value it is necessary to flip (sell) the option. But as expiration draws near, options that are in the money sometimes trade at parity, and this is when early exercise occurs. Options trading below parity practically beg arbitrageurs to exercise them for risk-less profit.

Where Stock Options Go

Option traders say that only 10% of options are exercised, which is generally true but not in all cases. Thus if you write a call, the odds against assignment are roughly 9:1, statistically speaking. But if a call is written ITM, the odds are quite high it will be exercised, despite the overall 9:1 odds. No matter where written originally, if the calls are in the money $0.01 or more at expiration, exercise is a virtual certainty. ATM and OTM options are never exercised, since it is cheaper to buy or sell stock in the open market than to exercise an option.

You have probably heard option seller’s state they are right 90% of the trades. This is due to only 10% or so being assigned. There is more to this story as we continue this journey.

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Stocks and Options: Similarities and Differences

Many investors ask about the fundamentals of options and the difference between types of options. Here I share some background on the fundamentals of option trading. Bonus: An active option trade is shown below for our Covered Call of the Week.

There are both similarities and differences between stocks and options. Some think of options as a stock substitute which is correct in some cases. However, it is important to know the differences as you include both in your investing plan.

Similarities:

  • Stocks and options are both securities. Options are technically derivatives since they relate to another security: shares of stock.
  • Stocks are traded on exchanges and also over-the-counter. Stock options trade only on exchanges regulated by the SEC.
  • Market makers buy and sell stock options as they do stocks.

Differences:

  • Stock represent an equity ownership interest in the company. An option is a contract.
  • Options expire on their respective expiration dates. An option not exercised by its expiration date expires worthless. Stocks never expire except when a company goes out of business.
  • Stocks are represented by stock certificates, although buyers often don’t see the shares because they are held in the broker’s street name. But options are maintained in the form of electronic book entry only, and there are no certificates that represent options.
  • At any time, there is a fixed number of shares of stock outstanding. However, there is no limit to the number of option contracts that can be created on a stock.
  • Holders of stock have the right to vote and receive dividends, but holders of options have neither, since the option is only a contract to buy or sell.

COVERED CALL TRADE OF THE WEEK

KKR & Co. (KKR)

The KKR Oct 25, 2019 covered call with a $27.50 strike price (selling at $0.85) could potentially yield a 3.89% return if KKR stays above $27.50 a share at expiration 26 days from now. The covered call has a 3 Key (Moderate Relative Risk) ranking. On 07/26/19, Argus Research set a $31.00 12-Month price target for KKR, which is currently trading at $3.68 below that target. By using this covered call strategy potential returns may be higher than simply holding the stock if KKR stays below $28.38 through Oct 25, 2019. The covered call strategy offers limited protection if the stock drops in price, but if the stock goes below $26.47 expect losses.

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Get the book on Amazon – Passive Income Monthly Plan: Create 60 Paychecks in 90 DaysLearn to create 60 paychecks per month in passive income. It’s simple – get started with $5 to build unlimited income. One of the truly passive income opportunities for monthly income – month after month!

Join the Monthly Income Newsletter voted the best value for option income trading

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Create a Passive Income Machine for Endless Income

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Covered Calls for Life

How do you measure the financial health of a business or public company? They are measured by the amount of cash flow they produce. All investors understand this concept as this leads to the earnings reported and financial strength of the company. Covered call investing provides a large amount of cash flow.

There are several styles of covered call writing. Some investors never do more than write calls on their portfolio stocks that can be an art within itself. Many investors buy stocks for the express purpose of writing covered calls on them and then sell the stocks or let them be called away at expiration. There are covered call strategies for the active trader who seeks action, for the shoot for the moon directional trader, for the lazy writer and for those with a long-tern horizon. Then the conservative crowd are fearful of risk and seeking low-risk or limited-risk trades.

As an investor, you can have covered call your way. No matter your lifestyle, if you have a computer or smart phone, there is a covered call strategy that will work for you. Is it riskless? No – but there are ways to lower your risk in the trade like insuring the trade.

If you are an investor interested in creating income streams. Then, covered call writing should be part of your portfolio.  You can write calls against your dividend stocks to enhance your income. I like to think about covered call writing as a monthly income stream.

I can sell a call option each month on a stock I own. This premium income is automatically deposited into my account at the transaction completion. Now, do this every month for a year. Then, add up the amount of the premium income for the 12 months and divide it by the purchase price of the stock. Compare this calculated covered call yield to the stock dividend yield. Which is higher? Typically, the stock dividend yield may be 3-5% but the covered call yield will be 15-20% yield.

For an income investor, a call yield this high is a great stream of income and it provides some downside price protection. Using the “rule of 72” will result in doubling your investment in 3.5 years. Even better, you can add $1,000s of income each month to a medium size portfolio.

The theory of covered call writing explained here should catch the eye of the income investor. This clearly shows why covered call should be a lifestyle-making portion of your investments. We like to say Covered Calls for Life is where it is at for multiple streams of income.

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Covered Calls for Income Investing

Why don’t more people write covered calls? There are numerous reasons. The general population is unaware such an investment exists. Only a hand full of investing services promote them but popularity has increased as more brokers push option trading strategies these days. Also, they do require a level of education to learn them in depth. The popularity increase has moved covered calls by leaps and bounds as it should. This is moving investing to the next level which is income investing.

Many financial advisors, brokers, planners and others in the finance industry either are not comfortable with covered calls or simple don’t understand the opportunity for covered calls in their clients’ portfolios. Many advisors are fee based and accept sizable commissions from funds to recommend their products. They make extra money when you buy these paid recommendations in place of a strategy such as covered calls. Basically, covered calls are just not on their priority list.

The information disseminated about covered calls by advisors and websites who don’t know the theory behind covered calls tend to paint the strategy as being dangerous with little return for the risk taken. Then, these same advisors recommend you to hold low performing stocks or churn your account to increase commissions. If they used covered call writing on the buy and hold stocks it would generate income that will lower overall risk of the investment.

How can producing income from an asset increase the inherent risk of owning an asset? This argument against covered call is nonsense on the face. For example, a real estate developer is usually wiling to hold properties that generate positive cash flow. If they don’t cash flow, then you have a tax write off and a hope to sale at a higher valuation – sounds like buy and hold right!  Advisors recommend buying stock and funds based on commissions. If you are in the hammer business, everything looks like a nail.

Brokers fear liability when customers lose money, even on self-directed option trades and they make little on option trades.  The education of clients on options will increase the risk of them deflecting to discount option brokers online once they feel comfortable with covered calls.

You can’t blame the financial industry for doing what is in their best economic interest any more than in other industries such as plumbers, electricians and other trades. Just recognize your interest are different than the financial industry in terms of your long-term investing. Advisors make money when you do and they make money when you don’t. Your choice is to rely upon their advice or handle your own investing. What should you do?

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Here is a great quote from the greatest options expert Larry McMillan: “You will have to predict something in order to profit, for only market makers and arbitrageurs can construct totally risk-free trades that exceed the risk-free rate of return.”  Regardless of your style, stock picking or options trading, you must make choices and you must predict outcomes.

At Get Rich Investments, we believe covered calls do require a prediction but they lower the overall risk of investing. They produce premium income to offset some downside in stock price movement. If used with dividend stocks, they add another layer of income. Then, we couple a portion of our portfolio to monthly dividend stocks to lower portfolio volatility and risk while maximizing total portfolio income.

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Proof that Option Income Writing is a Winner

With a covered call and protective put strategy, you have a win – win- win –win situation.  Here is what happens when the underlying stock changes:

  • Stock price increases –      you win by keeping the premium and either rolling up your call to a higher strike price or letting the stock get assigned;
  • Stock price is unchanged – you win by keeping the premium and possibly the stock to write more calls against it in coming expiration months;
  • Stock price slightly declines – Your amount of premium received will cover a slight decrease in the stock price so you win and keep the stock for more call writes for income;
  • Stock price declines aggressively – the protective put will gain value as stock prices decline closer or through the put strike price while you keep the premium and stock for more writes.

If you use the covered call with a protective put, you can create a great wining trade.  This is better for writing calls against a stock several months as this will offset the cost of buying a put for protection.  The protective put should be at least six months ahead of the current call expiration month when initially purchased.   This allows the investor to spread the put cost over the six month period to increase the profitability of the trade.  For example, if the protective put cost $300 to buy, the cost will average $50 per month on average.  However, if you exit the covered call position before the put expires, you can sell the put to recoup some of its cost.

In the case of a significant price decline, the put will become more profitable as it will increase in value.  The call writer can buy back the sold call
for pennies and sell a new call at a lower strike price to get more premium income.  After a few months of this, the trade should be profitable.

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The Biggest Mistake New Call Writers Make

Covered call trading is not like directional trading which has an objective to time the movement of a stock in the direction it is moving.  Covered writing is a game of regular, incremental returns.  The covered call writer’s objective is to collect the option premium for income without taking any damage to the downside of owning the stock.  The secret to success for the call writer is to make smaller, more consistent returns compared to a advanced option trader who makes many bets waiting for a 50% – 100% winner.  The biggest mistake by new call writers is writing a stock solely to capture the fattest time value premiums.

To improve the chances of being successful, the call writer should focus on stock selection.  The covered call trader should focus on 3% monthly returns.  However, a 15% drawdown on a trade will require 5 months of 3% returns to recoup the loss and get back to even.  This is why the Monthly Income Plan focuses on 5 star stocks signaling high quality stocks.

Why avoid the fattest premiums for a measly 3% monthly return?  The short answer is that high premiums often signal high risk, and writing calls on these options without regard to stock quality will eventually decimate your trading account.  There are two reasons that value premium becomes high enough to offer big returns:

1)   The stock is volatile and implied volatility is in line with the stock, or

2)   Implied volatility (IV) is significantly higher than actual volatility.

Simply, the higher the rate of return, the higher either actual or implied volatility (or both) must be on the options.  If two stocks had volatility of 60% we would expect the option premiums to be roughly comparable.  What if one stock had an IV of 25%?  This indicates a market expectation of less volatility in the future but it also means the investor is not getting paid for the 60% volatility risk he is taking on.  If the other stock had IV of 80% then the investor must determine what is causing the IV to be higher than the 60% actual volatility.  This usually indicates that the market is expecting some new event on the stocks such as news, announcement, earning or more.

If the IV is in line with the stock volatility, then the options are priced fairly so the decision comes down to – do you want to invest in the stock.  The rule is to AVOID stocks with spiking IV and look for a different trade.  To be conservative, look to write calls on stocks with a volatility of 40% or less.  If you are experienced and seek more income, look for stocks with volatility between 40% and 60%.  Anything above 60% I would consider high risk so proceed with caution.  You should at least look at the volatility of the stock before you invest to know what the risk of the trade may be over the coming option period.

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Selling Time Value of Options

When selling time value, you will use a different philosophy than those stock investors looking for a stock to go up in price.  Your gains will come from the time value of the options you will sell.  This approach to stock selection is unusual.  Most investors use fundamental analysis or technical analysis while you will use the time value of s stock’s options, tempered by fundamentals and long-term hold principles.

Deciding to create a covered call trade requires choosing an expiration month and strike price.  Option strategies require making modifications during the life of an option trade.  The option expiration month you select will have significant impact on the success of any option trade.

There are at least four different expiration months available for every stock on which options trade.  Initially, the CBOE set up only four months for options but later LEAPS were introduced so it was possible for options to be traded for more than four months on stocks with LEAPS options.  When stock options first began trading, each stock was assigned to one of three cycles: January, February or March.  Stocks assigned to January cycles will offer options in the months of January, April, July and October.  The same quarterly sequence will hold for the February and March option cycles.  Under the new rules, the first two months are always available but for the later months the original option cycles are used.

To select a stock for your covered call portfolio, you must have available a current option chain list.  You can select the expiration month based on the time value of the stock options and the strike price.  Then, if the stock meets your stock selection criteria, but it as the underlying stock in your portfolio.

To get an annual return of 20% or more, you must find available options with time value that will produce a 2% return each month or 5% each three months on the price of the stock.  Using the option chain list, you can calculate the percentage of stock price that the time value represents.  Of all the optionable stocks, you can find at least 5 to 10 stocks to consider.  If the time value seems attractive, then look at the fundamental and technical analysis to make your decisions.

Personally, I like to sell an option in the current or next month with a time value return of no less than 3%.  However, I will caution all covered writers  to proceed with caution if the time value return is very high as usually there is something pending with the underlying stock such as a news event, earning  release and other items.  Volatility can play a significant role in the pricing of options so the higher priced time value options usually have a significantly higher volatility.

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Option Selection for Covered Call Writing

Throughout the day, a person makes hundreds of decisions.  Paper or plastic? Double cheeseburger or salad?  Home brewed coffee or Starbucks Brew to Order?  And for option traders, which option to select from a large list of strike prices and expiration dates.

Option selection can be difficult especially for the new option investor.  Do you play a short-term or long-term option?  Do you take risk with OTM options or play it safe with DITM options?  Don’t let the selection process get too complicated for you.  Follow these three questions when making an option selection:

  1. What direction will the underlying stock go in the future?
  2. What are your expectations for the stock?
  3. What is your risk tolerance?

For the first question, don’t just guess where you think the stock will go in the next few months.  Look at the put/call ratio on the open interest tables.  Are there more calls than puts?  This indicates that investors feel the stock will rise.  If there are more puts than calls, then investors feel that the stock is going to decline.  You can use the put/call ratio to help determine the future direction of the stock.

The risk is in selecting the strike price of the option.  You have three choices: ITM, ATM and OTM.  Which one works for your stock?  An ITM has the highest price as it has intrinsic value because the stock price is higher than the option strike price.  This intrinsic value provides a spread for the option, making it less risky.   An ATM is when the stock price and option strike price are very close.  Generally, the price of the option is all time value and it has more premium than an OTM option.  This is the middle ground on the option risk scale.  The OTM option is the riskiest option play.  The option writer gets less premium income and takes on the risk that the stock will move higher to get a better return.  However, when the stock price does rise, OTM options have the greatest return.  You probably have heard about the more risk, higher return trade.

Now, you need to select what time to sell?  The more time the more premium income.  Selecting the right time to sell is up to the option trader.  Regular options are up to nine months and LEAPS are for up to 2 years.  You must decide how much premium you want to receive based on how long you want the trade to be.  For covered calls, most writers select the monthly option and repeat until called away.  However, this should be based on the objective of the covered call writer.

As income investors, we seek to create consistent monthly income by selling options to collect monthly premiums. We focus on the Monthly Income Report which is published the weekend following option expiration each month. To supplement members, we will publish additional trades and income opportunities.

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