With dividend-paying stocks or ETFs, anyone investing can greatly have their returns limited if depending only on dividends. The ordinary ways of investing do not offer cash flow that most traders want, especially during volatile markets when blue-chip assets have rather unpredictable patterns.[
This is where the covered call options strategy comes into play – a simple strategy that can greatly increase your income by adding a layer of profit to your dividends. This consists of building a steady stream of income by selling call options on assets that you already own, such as ETFs. Thus, it is very suitable for both novices and experienced investors who do not know enough about higher returns.
What is Covered Call Options Strategy?
The covered call options strategy is selling call options on shares of a stock or an ETF that you already own. There is your “cover” because, in the event that the option buyer exercises his right to buy, you do have the underlying shares to sell to him, and so you are not exposed to potentially unlimited risk.
The idea is straightforward: If you have a certain number of shares, you sell a call option for each 100 shares and agree to sell the shares at a particular price named the strike price by a specific date named the expiration date. And for doing that, you earn a premium—cash goes directly into your account and enhances your overall income. And if the stock price remains below the strike price, then the option expires worthless and you get to keep both the shares and the premium.
Why Covered Calls Are Perfect for ETFs like TLT
TLT, the ETF tracking the Barclays U.S. 20-Year Treasury Bond Index, is the most popular ETF for this strategy. It was a darn good environment when interest rates went through the roof and sent the price of TLT plummeting. Here’s why beginners like to use this ETF.
Consistent Income Through Dividends
- TLT pays monthly. A consistent cash inflow from dividends is added to the sale of income-generating options.
- It offers stable and predictable movement.
As a bond ETF, TLT tends to be less extreme in its price movements than equities that have high growth, which enables you to manage covered call trades with a low risk.
Capital Preservation
- Since TLT and other bond ETFs present a safer long-term investment compared to equities, it is a cushioned investment venture for any option trading instance.
Covered Call Strategy on TLT Step-by-Step
Let’s work through a simple example of how a covered call strategy might work with TLT and show how you might triple your income over a year.
Buy TLT Shares
- Let’s imagine you get out there and buy 1,000 shares of TLT at the price of $97.10 per share as of September 21, 2023. In total, you will pay $97,100.
- Now, you sell 10 call options because each call option protects 100 shares at the strike $91 with an expiration date a year out, in September 2024.
- You bring into cash $770 due to someone having paid you to sell him option contracts. This money hits your account right away for instant income.
Collect Dividends
- TLT presents semi-annual dividends, and for the purpose of this instance would amount to $3,618 for the calendar year, and thus would yield an annual yield of 3.99%.
Outcome at Maturity
- As of September 20, 2024, TLT’s shares are now bid at $98.88; the call options are in money because the stock price is greater than the $91 strike price; the option buyer exercises his right to buy, and you sell your shares at $91 a share.
- You retain the $770 from the calls sold, and add in the $3,618 of dividend money, and the $1,978 gain on the assigned shares, for a total cash return of 12.1%.
In this example, selling covered calls on TLT delivered triple the return over simply holding the shares for dividends alone, which would have returned just 3.99%.
Advantages of Covered Calls for Beginning Investors
Covered calls are beneficial in many ways, which is why it is a good strategy for new investors who want to earn more with minimal risks.
More Income
- Selling call options adds more income over any dividends paid. It is not entirely wrong to supplement income within a low-yield environment when dividends barely earn enough money to meet income objectives.
Reduces Risk Compared to Naked Calls
- Because you own the shares you sell call options against, you have no unlimited loss potential, which would be a problem with naked calls. If exercised, sell your shares at the strike price.
Flexibility
- Covered calls can be tailored to suit your needs. You can use a strike price and an expiration date that will meet your expectations of the stock. For example, you can select a strike price a little higher than the current price, which will allow some gain.
Higher Returns in a Flat Market
- In a market where you don’t expect prices to move much, covered calls can be a great way to generate income on stocks that are otherwise likely to sit idle.
Important Considerations for Covered Call Options
Though covered calls are very straightforward, there are a few important considerations to make before getting involved in this strategy.
Strike Price Selection
- The nearer you position the strike toward the current price, the more premium you can earn but will also increase the likelihood that you are selling your shares when the stock advances.
Impact of Dividend
- As long as you are buying dividend-paying stocks, note that option traders may opt to exercise the right to the stock even before the ex-dividend date, allowing them to acquire the dividend.
Market Outlook
- Covered calls are best utilized in neutral or slightly bullish markets. In a sharply rising market, selling calls may prevent you from more fully capitalizing on the gain, because you will be forced to sell your shares at the strike price if the option is exercised.
Tax Implications
- Premiums from the sale of calls and dividends are normally taxed like income, while the profit on shares will be subject to capital gains tax. So be careful to understand the tax implications before getting into it.
Other Strategies: Rolling Covered Calls
Once a covered call is initiated, it does not have to expire or have the shares called away. A common strategy, again one known as rolling, is used by many traders to extend the position even further and take in still more premium.
- Rolling forward: In case it is about to expire in the money—that is, when the price of a share is above the strike price—you can roll forward by buying it back and selling another one with a later expiration date.
- Roll Up and Out: You purchase the call option which is in the money and sell a new option with greater strike and expiry date. The benefit from this will be holding your shares while creating more income should you feel that the stock will move higher.
Conclusion
For the investor who wants to generate more income without taking extra risks from the market, the covered call options strategy might be the best very workable and effective solution. Applying this strategy on ETFs like TLT creates premiums and dividends that can give you a steady income while protecting you from losses in case the underlying price of the ETF goes down. Choosing very carefully the strike prices and the expiration date will make covered calls a quite adaptive income strategy for both beginners and experienced traders alike.
You could add covered calls to your trading plan and make those investments cash-generating assets that give you extra income and help realize your financial goals faster. For more, though, remember to stay updated to avail further sources of information.