When it comes to income investing, conventional wisdom dictates that we need to stay away from exciting stocks like Tesla and Nvidia in favor of more stable options. However, there is a strategy that enables us to have the best of both worlds – enter the “covered call” options play.
A covered call is a fairly straightforward options trade. To put it simply, a call option grants the holder the right to purchase a stock at a predetermined price before a specified expiration date. On the other side of the trade, the call seller must be ready to deliver the shares if the stock surpasses the “strike price” outlined in the options contract.
Now, selling a naked call option – where one sells an option for a stock they do not possess – can be quite risky. Let’s consider an example: if an investor sold a call option on Nvidia stock (ticker: NVDA) in mid-May when it was trading around $305, they would have received approximately $10 per share for selling the option. However, only days later, they would have had to purchase Nvidia stock for roughly $400 per share following the company’s remarkable earnings performance. Ultimately, they would have had to hand over the shares at the agreed price of $305. This blunder would have resulted in a quick loss of $75 per share – or $7,500 for a lot of 100.
Conversely, employing a covered call strategy – selling an option against a stock one already owns – significantly mitigates risk. Let’s revisit our previous example: a call seller who possessed Nvidia shares would have missed out on some potential gains but still managed to pocket the $10 options premium, effectively selling their Nvidia shares for around $315 each.
Admittedly, this example is an extreme case where the stock experienced an exceptional 24% surge in a single day. Consequently, selling calls on existing positions allows investors to generate income without completely missing out on significant upside potential. After all, it’s worth noting that most options are never exercised.
By embracing the covered call strategy, income investors can break free from the confines of traditional investing and make their portfolios work harder for them.
Generating Income with Covered Calls
Even highly volatile stocks like Tesla (TSLA) can be transformed into a lucrative source of income. Let’s say you hold 1,000 Tesla shares, you can sell one call option contract that gives the buyer the right to purchase 100 shares for $275 each until July 21 (compared to the current price of $270). By doing this, you would generate around $1,000, equivalent to approximately 0.4% of your total portfolio value. Repeat this process every month, and you could potentially earn over 4% annually, not bad for a stock that does not pay dividends.
It is important to note that selling calls does come with the risk of having your shares “called away.” To mitigate this risk, Gary Black, co-founder of the Future Fund Active exchange-traded fund (FFND), avoids selling covered calls on his Tesla position during events such as deliveries or quarterly earnings, where the stock tends to experience significant movements. As a Tesla bull, he aims to reduce the likelihood of having to hand over his shares to a call buyer.
Implementing a covered-call strategy requires careful consideration of strike prices and expiration dates. Selling options with higher strike prices reduces the risk of losing your stock but decreases their value.
According to Susquehanna analyst Christopher Jacobson, finding the right trade-off is crucial. The goal is to maintain reasonable upside potential while also earning a meaningful premium.
Unlike purchasing a dividend stock and forgetting about it, covered calls are more complex. Additionally, there are tax implications involved. If the option is exercised, it becomes a part of the stock’s sale price for tax purposes. On the other hand, if it expires worthless, it is treated as a short-term capital gain, similar to an ordinary dividend.
If you’re seeking income, covered calls can provide an effective solution.
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