Covered Calls

Want a better solution than simply relying on dividend paying stocks? Even if you’re inclination is to buy and hold, there is a better way to make your money work for you.

Investors feel safe holding shares of the strongholds of industry during bull markets. It seems like a smart call to buy and hold shares of Microsoft, Exxon and Proctor and Gamble and other tried and true companies. Those quarterly, semi-annual or annual dividends give shareholders a feeling of confidence that the company they’ve invested in is still earning a profit and rewarding their shareholders by paying out a portion of the income. But is that faith really justified or is it all smoke and mirrors?

If history has taught us anything it’s that companies can engage in some creative bookkeeping.  Think about it, how often have you seen a company report losses but still pay out dividends? Have you ever wondered how they pull that off? The answer is simple, companies will borrow money to pay out those dividends to keep up the illusion that all is normal.

For unsophisticated traders, this is a minefield, because they don’t always have the experience and education to understand the manipulation that is necessary to maintain the dividends. Less experienced traders will often just see the dividend percentage return and neglect to examine the fundamental underpinnings which might very well offer up some pretty clear warning signs to stay away.

As we saw in 2009 with the bank failures, companies that need cash can slash dividends. This leaves the companies investors holding shares that might be depreciating and not paying out the expected dividends.  This probably leaves you thinking, is there a better way?

Of course there is: the Covered Call. The covered call strategy is basically combining holding a stock with an option, the short call. Investors interested in holding stock positions can use a Covered Call strategy to proactively generate income on a regular basis. Investors are no longer dependent on the company to pay out dividends. Instead, investors can hold an existing stock position but sell call options at what are called strike prices.

What are strike prices? A strike price is simply a fixed price at which an investor has agreed to sell the underlying stock if and when the stock rises above that level within a set time period. This time period is defined at the beginning of the trade.

Investors will find that Covered Calls are profoundly powerful because it gives them the choice of not only generating an annual income with dividend paying stocks but also generating an income on a monthly basis. The increased frequency of payments means that compounding can take place at an increased rate which will greatly magnify returns.

Another facet of Covered Calls that makes them so attractive is that they give investors the chance to define what percentage income that they are targeting.  For example, some investors might be interested in generating a higher income upfront in exchange for a commitment to sell a stock at a lower price. Others might prefer to sell calls that generate a small premium and rely on capital appreciation of the underlying stock to make a profit. Each investors individual tolerance for risk tends to play a significant role in which route they choose to take.

It’s impossible to cover all the nuances of Covered Calls in a short article such as this, but know that it’s possible to use your creativity to craft a strategy that works with your own tolerances for risk and desire for reward. If you use a buy and hold strategy when buying stock, you MUST master Covered Calls to maximize your potential for income.

To learn more about the Covered Call strategy and its numerous applications that suit your risk tolerance, simply join our group of expert traders who will guide you in a way that best suits your needs.

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