A friend of mine suggested to me to sell covered calls on the dividend stocks that I own, in order to increase my income. Basically that means that I will sell an out of the money call option on a stock I already own at a given strike above the current price and collect the premium. This does sound appealing, because theoretically I could get two passive income streams from one stock. There are some risks with this strategy though, that make it less appealing to me:
First, when you sell an out of the money covered call option, you are basically betting that your stock would not increase above the strike price at which you’ve written the options. Thus if I owned Pepsi at $69, share and I sell a February covered call at the $75 strike; I would be betting that the price of Pepsi would not increase over $75 over the period. And I always expect that my stocks would go through the roof in any period, otherwise I wouldn’t have bought them in the first place.
Second, if the price rises to 80, I would not be able to participate in the upside gains above 75, because I am obligated to sell it to the call buyer to whom I wrote the call option to. The only scenario in which I will keep the stock and the premium is when the stock price does not increase above $75. This strategy seems inferior because it assumes that investors could time the market by betting whether or not the stock would be above/below the strike price at expiration. Studies have shown that investors are pretty bad at timing the markets, because the majority always seems to be selling at the bottoms and buying at the top. It also seems inferior because you are limiting your upside, and leaving your downside wide open. You are selling your rising stocks and keeping your losers, while earning some income in the process, which in reality is eroding your capital gains. The psychological weak points of this strategy is that most investors always believe that their stocks would be rising over time, so betting against your own portfolio in terms of covered call selling seems counterintuitive.
If I were simply interested in income, I would put all of my money in a bond yielding me 5% annually and simply compound the interest. I am in this game not only for the income potential but also for the capital gains. Thus I am not a believer in the covered call strategy. If I thought that my stock would not increase a lot, then I would sell it and buy a stock that I believe would increase a lot. Tomorrow I would write about another options strategy for generating income.
Relevant Articles:
- Dividend Aristocrats List for 2009
- Dividend Aristocrats
- Best Dividends Stocks for the Long Run
- Best High Yield Dividend Stocks for 2009
- Best CD Rates
- Covered Call Options Strategy for cutting losses
Popular Posts
-
I review the list of dividend increases each week, as part of my monitoring process . I follow this process in order to monitor existing in...
-
I review the list of dividend increases every week, as part of my monitoring process. I typically focus my attention to companies that have...
-
I am a big fan of frugality. I believe that frugality is all about the most efficient use of scarce resources. This could mean thinking outs...
-
I review the list of dividend increases every week, as part of my monitoring process. It's one of my processes to monitor existing holdi...
-
I am a big fan of Dividend Growth Investing. I like the mental model of Dividend Growth Investing, where a rising stream of annual dividend ...
-
Several of the large banking institutions in the US passed the Stress Tests imposed by the Federal Reserve. As a result, they announced thei...
-
The best decision I ever made was to invest in my own financial education. Everything I have done is easily achieved by anyone else with a ...
-
Warren Buffett's investment in Coca-Cola (KO) is really fascinating. He started buying it in 1988 after the 1987 Stock Market crash. Buf...
-
Warren Buffett is the best investor in the world. I've dedicated a ton of time studying him and writing about him on this humble site . ...
-
In my investing, look for businesses I can understand that have some sort of a competitive advantage that translates into consistent earn...