What if you could collect cash when the market wasn’t moving? Using the strategy I’m about to show you, you can. This strategy may seem a little complicated at first, but rest assured this could be the easiest money you’ve ever made…all while the market continues to flop around.

The technique I’m talking about is writing covered calls. You might also hear it described as selling covered calls. I promise, this is just as easy as buying and selling stock. You just need to know what to look for.

Covered calls are instruments used by income investors to collect instant income and reduce downside risk. They come with no more risk than the stocks you already own, and they can be applied to the same stocks you already have in your portfolio. You can literally multiply your dividends with this simple strategy.

Simply put, a covered call works like this: you own shares of a company that you expect to languish in the short-term. To take advantage of this prediction, you sell call options on your stock, creating a short position (selling calls is a way to bet against a company) that offsets your long position. In exchange for writing the call, you get to pocket the premium that buyers pay to purchase the option.

Your best profit potential for a covered call occurs when shares trade sideways.

With that in mind, here’s a look at six key factors to keep in mind when writing covered calls…

Things to Keep in Mind When Dealing with Covered Calls

Covered calls aren’t for everyone. But if you are thinking about starting this strategy for your own companies, here are a few key points to keep in mind…

1) Always Remember the VIX. It’s important to keep a lookout for the Volatility Index to drop too far. A day here or there below our artificial watermark of 25 is nothing to be worried about. On the other hand, if you are watching premiums fall every week, you may be exiting a covered call market.

2) Don’t Disrupt Your DRIPs. Covered calls should be used only on stocks you don’t plan on holding for the next several years. If you are reinvesting your dividends through a set plan, you should avoid any scenario that could decrease your position…including covered calls. DRIPs and covered calls are two important income strategies. But they should never be combined.

3) Be Picky About Which Stocks to Use. Some stocks just don’t come with the right options to use this strategy on. Others have such illiquid options that they’re not valid covered call candidates.

4) Be Aware of Upcoming Events (Dividends, Splits, Mergers, Acquisitions, Etc.). There’s nothing like making the perfect move in the market just before realizing a devastating piece of legislation is about to be signed into law or a bad dividend is about to be paid out to shareholders and immediately dilute your new shares. The same can happen with covered calls. If there’s a large piece of news that will shake up the company, you might just lose your new premium faster than you can spend it. Know what is happening to the underlying investment before putting more money down on the movement of its shares.

5) Don’t Rely on Covered Call Income. As we noted in No.1, the options market could dry up without warning and leave you without that extra income. So don’t start spending it before you’ve booked the deal. Dividends are more reliable, because a board of directors usually oversees that decision. Option premiums are decided by how many fearful speculators there are in the market at any one time. That’s not exactly the safest bet.

6) Make Sure You Are Truly Covered. So many people make dumb mistakes by accident. This might be the worst one. Before you ever place a sell/write order on a call option, make sure you already own the required shares. One option contract (either call or put) is worth 100 shares. So make sure you have 100 shares before you sell a contract. And make sure you don’t sell those shares before your options expire. You never know what will happen in the stock market on any given day. Just look at what happened to Goldman Sachs on expiration day in April. Shares fell 20%, abruptly changing the options market by the thousands of percentage points.

Covered Calls Without the Hassle

One of the main hurdles investors have when looking at covered calls is the amount of cash it takes to do it. To start, you need at least enough to buy 100 shares of a company. Take blue chip behemoth General Electric (NYSE: GE), for instance. Shares are right around $16.25. That means it takes a minimum of $1,625 you need to tie up in GE stock.

For some, that might be too much to put into one position. For others, the actual trading of covered calls takes too much time. Fortunately, there’s a way around these hurdles.

Over the past decade, a number of “enhanced income” funds started popping up. That’s just the marketing name for covered calls and dividends. These funds buy up large amounts of stock from major companies — many in our own portfolio — and sell calls against them. So while some of their stock could get called away, they don’t ever put their entire holdings at risk. Meanwhile, they collect dividend payments the whole time.

Since the covered call strategy is so cash intensive, it’s much easier for multibillion dollar funds to do all the heavy lifting. They pass on the income — from both dividends and calls — to fund holders. And the best part is, you don’t have to own hundreds of shares of any company. You can literally get into covered calls for about $10 — the price of the fund’s shares. They’re an excellent alternative to covered calls for more hands-off investors.

Sincerely,
Jim Nelson
Penny Sleuth

July 30, 2010

Jim Nelson

Jim Nelson began his investing career during the tech boom at age 14 – with purchases of Starbucks and AOL. Early inspiration came from an old Tweedy Brown whitepaper: “What Works in the Market.” He graduated with a degree in Political Science from Pittsburgh University, Nelson focuses on income investing, including dividends, covered calls, and fixed-income. Additionally, he covers MLPs, ADRs, utilities, consumer staples and tobacco. Nelson is the managing editor of Lifetime Income Report.

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