by Investing Daily, Investing Daily
— this post authored by Scott Chan
Investing Daily Article of the Week
If you invest in stocks, there are two ways to make money.
The simplest way is to sell the stock at a higher price than you bought it. This means the stock price went up. This is capital appreciation.
Please share this article – Go to very top of page, right hand side, for social media buttons.
The other way is through dividend income. U.S. companies that pay a dividend usually do so once per quarter like clockwork.
If you have a million-dollar portfolio of stocks that pay a high dividend, you will receive a decent sum every year from dividend alone, so investing in all conservative stocks isn’t a terrible idea for people who are just looking to preserve what they already have.
For folks who want to grow wealth through their investments, though, the money will be made mostly through capital appreciation. A common way to do this is to invest in companies that are growing at a fast rate.
Besides being more volatile, one downside to growth stocks is that they usually don’t offer a good dividend. In the case of young companies, they often pay no dividend at all.
If you want fast growth, but you also want to receive some income, there’s an easy way to do this even if you hold a portfolio of mostly non-dividend payers: selling options.
Covered Calls
The least risky way to generate income from options is to write, or sell, a covered call. This means selling call options against a stock you already own. Stocks with high implied volatility – the market expects big price movements – generally offer the highest premiums.
I will use streaming entertainment provider iQIYI (NSDQ: IQ), a stock I wrote about two weeks ago, as a simple example.
The day after my article was published, iQIYI reported excellent fourth-quarter results and the stock jumped 22% in one day, so it has already contributed a good amount of capital appreciation lately, but it can also help generate income.
Here’s How
Let’s say you own 200 shares of IQ. You are happy that the stock price has risen lately, but knowing that the stock is volatile, you will be content to take some profits off the table if the stock reached $35.
You see that you could sell June 21, 2019 $35 calls at about $1 per contract so you sell one contract for $100 – one option contract equals 100 shares of the underlying stock. (All quotes I mention herein are actual quotes at the time of this writing.)
With IQ at about $27 a share as of this writing, that $1 per-share premium is the equivalent of a dividend yield of 3.7%. And you can do this again once the first option expires. If you did exactly this twice in a year, the premium you receive would be the equivalent of a 7.4% dividend yield.
You receive that premium right away. You didn’t even have to wait for the quarterly dividend payout.
Different Scenarios
Come June 21, if IQ is below $35 then you keep all your shares. If IQ is above $35 but less than $36, you would lose the 100 shares but actually come out ahead. Don’t forget to take into account that $1 per-share premium.
You will only lose on the trade if IQ happens to be above $36 a share if the option is exercised since you will receive $35 per share (and the $1 premium) no matter the market price of IQ. In other words, if you hadn’t sold that call, you could have sold the stock at a higher market price and realized an even higher gain.
By selling a covered call, you do cap your potential upside. That’s why it makes sense to pick a strike price at which you’d be happy to lock in some gains anyway. If IQ goes from $27 now to $35 on the strike date, that’s a 30% rally in less than four months. You have to ask yourself if you are content with taking a gain like that.
In my example, even if you lost 100 shares at $35 a share, you would still have 100 shares left.
Many Choices
Instead of a June call, you could choose to sell a call further down the road. The January 17, 2020 $35 call can be sold for $3. That’s the equivalent of an 11% yield.
Selling a longer-dated option gives the stock more time to reach the strike price, but in return you get a higher premium.
You could also sell a put at the same time. For example, the June 21, 2019 $15 put could be sold for about $0.95 (or $95 per contract).
In this scenario, the $195 total premium is yours no matter what. (Again, I am not counting the commission, which if you use a discount broker shouldn’t be very much.) And if IQ trades between $15 and $35 on June 21, you will keep all of your shares.
This would make sense if you plan to buy more IQ shares if the stock fell to $15 anyway (a 44% fall from the current price). The downside here is that IQ could fall way below $15 by June 21, in which case you would be overpaying. Plus, your broker will require you to hold enough cash or cash equivalents as reserve in case the put option is exercised. Selling one $15 put would require $1,500 held as reserve.
If you don’t mind possibly losing all 200 shares at a specified price, you could also sell options against all 200 of your shares to increase the premium.
.
