Are you thinking of selling covered calls on dividend stocks, to earn more income? If so, you came to the right place. In this article, I’m going to go through the entire process. Regular investors like you and me sell covered calls every day. And, this article assumes you already know the basics of selling covered calls to generate weekly or monthly income.
Also, in this article, I’ll go over when’s the best time to sell covered calls, how to make the most money from them, and when to close out the trade. I’ll also go over the risks of selling covered calls. Yes, there’s always a risk and it might not be what you think.
What is a dividend stock?
Now that we got all that out of the way, let’s dive right in. So you’re here because you want to know more about selling covered calls on dividend stocks. As a primer, dividend stocks are shares in companies that pay a dividend. Many companies pay dividends, and the best companies are ones that are the most established, like the Dividend Aristocrats and the Dividend Kings. Generally, dividends are paid out of net profits, but, it’s more of a best practice than a rule. Also, they are often paid quarterly, however, some dividend companies also pay monthly, semi-annually, or annually. The dividend amounts are often the same, or greater each period. However, when times are tough, companies will often cut the dividend. The nice thing about selling covered calls is that no matter what happens to the dividend, you’ll still be able to sell the option.
Related read: Don’t Miss These 12 Stocks Pay Monthly Dividends
What is a call option?
A call option is a contract that investors like you can I can buy and sell. For the purposes of this article, we’ll be discussing American-style call options. Investors who sell American call options give the buyer the right, but not the obligation to BUY a specific underlying security, like a dividend stock, from you, the seller, at a specific price at ANY point until the option expires. Now, there’s another type of option, called European options – and those give the buyer the option to exercise only on the expiration date. But, for this article, we’ll be only considering American options.
One thing to know is that to sell covered calls on dividend stocks or any stocks for that matter, you’ll need a margin account. Also, your broker will need to approve your account for selling options. These approvals might happen automatically, or, you might have to request them. Your broker might also ask you if you’re looking to sell “naked” options – this is where you don’t own the underlying security. Selling naked call options comes with theoretical unlimited risk and might be harder to get approval for. However, to sell covered calls, the risk is very low, and practically zero to the broker. So, the approval is usually easy.
What is a covered call?
Now that you know the mechanics of an American-style call option, the part that makes it covered is the fact that you must own at least 100 shares of the underlying security (the stock) for each call option contract. But, the number doesn’t have to be round. I mean, in this case, with Abbot Labs, if you sell two contracts, you’ll need to already own at least 200 shares. You can have more, like 210, 250 shares, or more. But to sell two covered calls on this dividend stock, you need 200 shares, minimum. This way, if your option gets exercised, these are the 200 shares that will get sold to the call option buyer, at the strike price.
Of course, as an option seller, your goal is for the stock to trade below the strike price so that your option expires worthless at expiration. This way you get to keep your shares AND the income you made from selling the option. Stay tuned because a little later, I’ll show you how you can find call options that have an 85% chance or even 90% chance of the option expiring worthless, and you can do it week after week, month after month! It’s kind of like getting your cake and being able to eat it too!
Example of a call option
Let’s look at how selling a covered call works with this example Abbot Labs‘ stock, a member of the dividend aristocrats. At the time of publishing, Abbot is trading at around $118.00. To find an option, search for the ticker on NYSE.com, click on the options tab, we can see some of the call options on the left and put options on the right. The first thing we’ll want to do is pick an expiration date, and I’ll pick Oct 29 as it’s about a month into the future from today. I find that picking an option a month or more into the future often gives me a better chance to lock in a profit down the road, stick around and I’ll talk more about that later.
So here, we can see a list of strike prices. And the bid price is the price someone will pay for the particular option. So, let’s take this sightly out of the money option, the $126 strike, that you can sell for $0.72 – or $72 for one contract, less any commissions. The $72 is the options premium, or income, that you get to keep, regardless of what happens.
If by Oct 29 Abbot Labs stock is still trading below the strike price of $126, it will expire worthless, and the $72 is yours to keep. But, if it’s trading over $126 at any point UP until the expiration, the option buyer can, and will likely exercise their right to buy the stocks from you, at $126 each.
Who keeps the dividend?
Now, you might be wondering about the dividend. First, if the company pays a dividend, it will already be factored into the price of the option. Taking Abbot Labs again as an example, if you sell a covered call option on it, and between now and the options’ expiration a dividend is paid out, the dividend amount will already be factored into the option price when you sell it. So you get to keep the dividend AND the call option – and many investors make two even three or more times their income by using this strategy. Double-dipping is the colloquial term.
Related read: How to Become Financially Independent
How are call options priced?
Call options are priced based on their intrinsic value (The difference between the strike price and the underlying equity), and time value – which is the rest of the value. Both “time to expiry” and “volatility” influence the time value heavily. Putting it differently, Investors will make the most money selling call options on dividend stocks with longer expiration dates, when volatility is high. If volatility is low, and the expiration is sooner, the option premium will be less.
How much can you make selling covered calls on dividend stocks?
In case you’re wondering how much you can make selling covered calls, it’s not unheard of to get 20%-25% on an annualized basis selling covered calls. How much you earn depends on how volatile the stock currently is, the strike price, and the expiration date. In general, when the markets are calmer, you’ll have to sell calls closer to the money, with an expiration date that’s further out. However, the more volatile the markets are, the higher the monthly income you’ll earn from selling covered calls. And many call sellers LOVE it when stocks are volatile because even if it means the risk of getting exercised is higher, volatility means more income!
Related read: Can You Retire at 62 With 300k
The risks of selling covered calls on dividend stocks
You might be wondering about the risks of selling covered calls. To be sure, selling covered calls is a very conservative investing strategy. So, the risks of selling covered calls on dividend stocks are low. However, there are some risks to think about.
The first risk is that if the underlying equity rises above the strike price, and you’ll be forced to sell. Now, if you have owned the stock for a long time, you might have a significant capital gain, and if your option is exercised, that gain will be crystallized. Is it a big deal? Well, take our friend Abbot Labs again, and let’s say you’ve owned it since 2016 when it was trading around $40. If you had to sell your stocks today, you’d have around $7800 in capital gains to deal with at tax time, for each call option contract sold. And depending on your tax rate, this could result in a significant tax burden.
The stock falls
The second risk is that the stock falls during your covered call trade. If that happens, don’t panic. If the stock falls, just know you won’t be able to sell your stock until you first close out your call option. And that’s how you mitigate any call option risk. You close out your trade by buying back the exact same option that you initially sold. Your broker might know this as a “buy to close” order.
Either way, when you buy back the option, you’ll have to pay for it, and no matter what, it’ll eat into your profits. In fact, if the stock has risen above the strike price, and you want to close out your trade, you might even have to pay MORE for your option to close out that leg. But wait, it doesn’t end there!! One way to fix the trade and make some more money is to roll the call option. Rolling the call option means first buying back the option you originally sold (if you haven’t done so already), and then you sell another call option, with a slightly higher strike price, and a little further down the road. It’s kind of like kicking the can until the option expires worthless and you keep 100% of the income.
Assignment, or early assignment risk
Third, there’s assignment risk. With American-style options, the call buyer can exercise their right to buy the shares from you at any time before the expiration. And while rare, early assignment can happen if a dividend is called before expiration. Or, there’s some surprise where the buyer feels it’s in their best interest to buy the stocks at the strike. Again, it’s rare. Just know it’s possible.
How to find covered calls worth selling
The goal of every option seller is to let the option expire worthless. If you’re looking for the best chances of having an option expire worthless, I use an options scanner to scan the marketplace for different options. And We can continue using our Abbot Labs as an example. To scan for options, I can open my Options Samurai account, and start by clicking “compose new scan”.
Then, I’ll input in the stock, ABT, remove the option volume, remove expiration, remove moneyness, remove return – but I’ll keep annualized return, add open interest, and set the probability of expiring worthless to 90%. This means any call options that come up in the results will have at least a 90% chance of expiring worthless. Then, I hit “run scan” to see the results.
And in the above example, you can see the Abbot Labs $123 strike is selling for around $.16 or 16 per contract expiring Oct 2 – in just 2 days. The annualized return is 14.44% and there’s open interest, meaning there are currently people with orders ready to buy this option at this price. And best of all, there’s a more than 90% chance the option will expire worthless. Not bad!
Beware of the earnings date
One thing to note is the earnings dates. Stocks tend to be more volatile leading up to and shortly after their earnings call. And as a result, if the stock rises above your strike price by expiration, well, expect the option to get exercised. For this reason, I prefer that an option expires at least a week or even two after an earnings date.
How to sell a covered call option on a dividend stock
To sell a covered call on a dividend stock, you’ll first need at least 100 shares of the company in your brokerage account for each contract you want to sell. So, if you want to sell 2 contracts at the same time, you’ll need 200 shares of the company. And, You can have more than 200, it’s just for 2 contracts, you need 200 shares.
Once you’ve settled on a specific option using a scanner, either through your brokerage or another company like Option Samurai, you can instruct your brokerage to “sell to open” X number of contracts of a specific company. You’ll also need to input the expiration date and the strike price. If the brokerage gives you a quote, the bid price is the amount someone is willing to pay. And remember, the total income will be the bid price, X100 X the number of contracts. So, if the bid price is 50 cents, and you sell 3 contracts, you’ll get $150.
One thing you’ll want to be aware of is your trading commissions. Some companies charge upwards of $25 to trade one option contract. And if your option income is only, say $40, maybe it’s not worth it. There are other brokerages that have much cheaper commissions. And some are absolutely free.
Calculating the returns
If you’re a numbers guy, like I am, you’ll probably want to calculate your returns. So, here’s how you do it. There are two returns you’ll probably want to know. The first is the total return. And the other is the annualized return. The total return is the amount of the income, divided by the stock price. Let’s take our Abbot Labs example again. Let’s say you got 72 cents for selling the call option, and the option expired worthless, your total return is around 0.6%.
Now, 0.6% might not sound fun, but what if that was just after a week, or a month?
If the call option is exactly 4 weeks out, the annualized return would be (option income x 52 weeks x 100) / (stock price x weeks left for call option expiration)
(.72* 52 * 100) / (118.00 * 4) = 7.93%
7.93% is far more interesting than 0.6%, isn’t it?
Break even point
Another thing to consider is the break-even point. The break-even point is the cost basis, minus the option premium.
Using the Abbot Labs example, the stock was trading at $118. Let’s say you simultaneously bought the stock and you sold the $126 option and collected 72 cents in option premium. Your break-even point is $117.30. And this is probably only important if you bought the shares and sold the call option at the same time.
What happens at expiration
At expiration one of three things will occur:
- The option is In-The-Money (Meaning the stock is above the strike). If this happens, the buyer will buy your shares at the strike price. Using the Abbot Labs example, if you sold 2 contracts at the $126 strike, you’ll get $25200 deposited in to your account (or 2 * $126 * 100 )
- The option is at-the money meaning the stock is the same as the strike price. In this case, the option will most likely expire worthless, and you keep your shares, and the option income.
- The option is out of the money. This is exactly what everyone wants. The stock price ends below the call option strike price. In this scenario, the option expires worthless, and you keep your shares and the option income.
Yes, you can sell covered calls in a traditional or ROTH IRA.
Selling covered calls require a margin account, which is not an attribute of a 401(k). However, if you roll over your 401(k) in to an IRA, you’ll be able to sell covered calls. Be sure to contact a CPA or equivalent to ensure the rollover is done correctly.
Selling covered calls on dividend stocks can be a genius way to double, or even triple your income. But, don’t get too greedy. Stick to high-quality stocks, like the dividend aristocrats, and if you’re going to sell covered call options, stick with those who have a high probability of expiring worthless. This way, you can hopefully repeat the process over and over!
*Disclosure: On the date of publication, Rick Orford did not have (either directly or indirectly) any positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. The information herein is based solely on my personal opinion and experience. All investments hold inherent risk, and the information provided should not be interpreted as any kind of guidance, recommendation, offer, advice, or suggestion. Any ideas and strategies discussed on this channel should not be implemented without first considering your financial and personal circumstances or without consulting a financial professional.