Dividend stocks are valuable for investors looking for income. Yet sometimes, you want to own a stock that doesn’t pay a dividend, especially if you want maximum exposure to a fast-growing upstart that doesn’t yet have the excess capital to return to shareholders in the form of dividends. If you need to generate income from all of your stock holdings, you might think that high-growth stocks are essentially off-limits.
Yet there’s a strategy you can use to generate income even from stocks that don’t pay any dividends. The strategy involves options, which many investors see as risky. Yet used correctly, options techniques don’t always increase risk levels, and this one in particular can help serve a valuable need while letting you own the stocks you truly want to hold in your portfolio.
The basics of covered calls
The covered call strategy can help produce income from a stock position that you own. In order to implement the covered call strategy, you need two things: shares of stock, and the ability to write a call option against those shares. A call option gives the buyer the right, without any obligation, to purchase a set number of shares at a pre-specified price between now and the expiration date of the option. The buyer pays a premium to the seller, and in exchange, the seller agrees to sell the shares to the buyer if the buyer exercises the option.
Here’s an example of how the covered call strategy can work. Say you own 100 shares of stock worth $100 per share. The stock pays no dividend, but you want income. You could write a covered call agreeing to sell your stock to the call option buyer for $120 per share anytime in the next three months. In exchange, you’d receive a certain amount of money per share up front. Regardless of what happens with the option, that money is yours to keep.
2 outcomes with covered calls
Each time you use the covered call strategy, it can end in one of two different ways. If the share price stays below the agreed-upon price in the option — also known as the strike price — then the option buyer won’t want to exercise the option. It would be cheaper simply to purchase shares at a lower price on the open market, and so the option will expire worthless. You’ll simply get to keep the option premium you received when you first wrote the covered call.
If the share price rises above the strike price, however, the option buyer will exercise the option. You’ll be obligated to sell your shares for the agreed-upon price, even though you’d be able to get more if you just sold the shares on the open market.
That second outcome isn’t always what investors want to do. Instead, you can buy back the option just before it expires, at which point you’ll typically pay the difference between the market price of the stock and the strike price in the option. Depending on how much the stock price has gone up, however, that can involve paying a lot more money than you received when you wrote the covered call in the first place.
How much income can you get from covered calls?
The amount of income you’ll get from writing a covered call depends on how high you set the strike price. The higher the strike price, the less income you’ll get, but you’ll retain more potential upside and reduce the risk of having your stock called away from you due to option exercise.
Also, you generally want to write covered calls when their prices are as high as possible, and that comes when the level of volatility in the market is highest. Recently, volatility levels have pushed dramatically higher, making now a smarter time to consider covered calls than at times in the past when the market was calmer.
Looking at some of the largest non-dividend paying stocks in the market, options expiring four months from now with strike prices about 10% higher than the current market price currently will pay premiums of between 1.5% and 3% of the stock price. That might not sound like much, but if the option doesn’t get exercised, then you can then take the stock and write another covered call. Four-month expirations let you do this three times a year, and a yield of 4.5% to 9% is pretty impressive.
The price you’ll pay
The thing to be careful about writing covered calls is that you do give something up: the right to gains above the strike price you set. Yet you retain the full downside risk if the share price goes down. For some, that trade-off isn’t worth it, especially if the whole point of owning a high-growth stock is to see its share price soar.
For tried-and-true income investors, though, that price is worth paying in order to squeeze some income from what would otherwise be non-income producing stocks. Covered calls aren’t without their risks, but they’re worth a closer look if the income they can provide is of primary importance to you.
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