Selling Covered Calls for Monthly Income
Investors are constantly seeking the holy grail of income strategies and while one doesn’t exist, selling covered calls and poor man’s covered calls for monthly income might be the closest we have, as investors, to the perfect income strategy.
Today, I’m going to focus on selling covered calls for monthly income. And next week, I’m going to do a deep dive in poor man’s covered calls for monthly income which is actually my preferred options strategy for creating monthly income.
Covered calls are one the best strategies the market has to offer. Hands down.
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And for those that wish to create a steady stream of income with a portion of their overall capital without taking on significant risk, well, it doesn’t get much better. Unfortunately, in this world of “unrealistic return assumptions” the power of investment strategies, with realistic returns, goes unnoticed.
I’m not going to talk about the returns yet. I’m going to go through a few current examples to show you what to expect given the level of risk you wish to take. And then you can decide if selling covered calls for monthly income is a strategy you might want to incorporate into your overall portfolio.
The initial barrier to entry when it comes to selling covered calls for monthly income comes in security selection. Simply stated, implied volatility (IV) is the key to security selection. Implied volatility tells us how much risk and return we should expect to see over a 20-to-45-day time frame, so that we can form a realistic plan for creating monthly income.
Next is the price of the security. Just because the IV of a stock fits within our range doesn’t mean that the stock works. We must be able to afford to buy, at least, 100 shares of the security while maintaining proper position size in our overall portfolio.
I’m going to keep the price of each security to a limit of $75 per share, or $7,500 per covered call. Also, I’m going to sell at-the-money calls to keep things consistent. Oftentimes I like to sell calls with a delta between 0.20 and 0.40, but again to keep the comparisons fair and consistent I want to use the at-the-money calls for each example.
Of course, for those with larger accounts, my price limitation might not be the best choice. Especially, if you prefer to use one of the major market ETFs, like the SPDR S&P 500 (SPY), SPDR Dow Jones (DIA), Invesco Nasdaq 100 (QQQ), or even iShares Russell 2000 (IWM). I will do another post on the major market ETFs at a later date. Stay tuned!
Implied Volatility 10 to 25
Merck (MRK) is currently trading for 75.27 and has an implied volatility (IV) of 20.19%. Moreover, the stock has a beta of 0.42.
If we decided to buy 100 shares of MRK, we could do so for a total of $7,527 and immediately sell some at-the-money calls for approximately $1.64.
Covered Call Trade:
- Buy Merck (MRK) stock for roughly 75.27
- Sell MRK September 75 calls (37 days until expiration) for $1.64
Static or Return on Premium: 2.23% over 37 days
Covered Call Return (if assigned): 2.23%
So, as you can see above, we have the potential to create 2.23% every 37 days, or approximately 22.3% a year using a fairly conservative stock like MRK. This is our baseline and should be our expected return in premium for stocks with a fairly low IV.
Implied Volatility 25 to 40
Micron Technology (MU) is currently trading for 74.14 and has an implied volatility (IV) of 40.38%. Moreover, the stock has a beta of 1.30.
If we decided to buy 100 shares of MU, we could do so for a total of $7,414 and immediately sell some at-the-money calls for approximately $2.79.
Covered Call Trade:
- Buy Micron Technology (MU) stock for roughly 74.14
- Sell MU September 75 calls (37 days until expiration) for $2.79
Static or Return on Premium: 3.91% over 37 days
Covered Call Return (if assigned): 5.12%
So, as you can see above, we have the potential to create 3.91% every 37 days, or approximately 39.1% a year.
Implied Volatility 40+
Ebay (EBAY) is currently trading for 67.67 and has an implied volatility (IV) of 50.48%. Moreover, the stock has a beta of 1.04.
If we decided to buy 100 shares of EBAY, we could do so for a total of $6,767, and immediately sell some at-the-money calls for approximately $3.00.
Covered Call Trade:
- Buy Ebay (EBAY) stock for roughly 67.67
- Sell September 67.5 calls (37 days until expiration) for $3.00
Static or Return on Premium: 4.64% over 37 days
Covered Call Return (if assigned): 4.64%
So, as you can see above, we have the potential to create 4.64% every 37 days, or approximately 46.4% a year.
As you can see, implied volatility offers great insight into how much premium you should expect to receive. And while the IV of stocks changes due to certain events (earnings, etc.), it is a wonderful guideline for how much premium (potential income) you should expect to receive.
I like to take a diversified approach, using stocks that fall into different levels of IV, but risk is in the eye of the beholder, and I just want to make everyone aware of the choices out there so that we can make the most informed decisions possible given our own risk tolerance and investment goals.
Next week, I’m going to discuss the benefits of using poor man’s covered calls as an alternative to covered calls.
As always, if you have any questions, please feel free to email me or post in the comments section below. And if you haven’t had a chance, please sign up for my free newsletter where I offer options education, research, and trade ideas.