A friend of mine suggested to me to sell covered calls on the dividend stocks that I own, in order to increase my income. Basically that means that I will sell an out of the money call option on a stock I already own at a given strike above the current price and collect the premium. This does sound appealing, because theoretically I could get two passive income streams from one stock. There are some risks with this strategy though, that make it less appealing to me:
First, when you sell an out of the money covered call option, you are basically betting that your stock would not increase above the strike price at which you’ve written the options. Thus if I owned Pepsi at $69, share and I sell a February covered call at the $75 strike; I would be betting that the price of Pepsi would not increase over $75 over the period. And I always expect that my stocks would go through the roof in any period, otherwise I wouldn’t have bought them in the first place.
Second, if the price rises to 80, I would not be able to participate in the upside gains above 75, because I am obligated to sell it to the call buyer to whom I wrote the call option to. The only scenario in which I will keep the stock and the premium is when the stock price does not increase above $75. This strategy seems inferior because it assumes that investors could time the market by betting whether or not the stock would be above/below the strike price at expiration. Studies have shown that investors are pretty bad at timing the markets, because the majority always seems to be selling at the bottoms and buying at the top. It also seems inferior because you are limiting your upside, and leaving your downside wide open. You are selling your rising stocks and keeping your losers, while earning some income in the process, which in reality is eroding your capital gains. The psychological weak points of this strategy is that most investors always believe that their stocks would be rising over time, so betting against your own portfolio in terms of covered call selling seems counterintuitive.
If I were simply interested in income, I would put all of my money in a bond yielding me 5% annually and simply compound the interest. I am in this game not only for the income potential but also for the capital gains. Thus I am not a believer in the covered call strategy. If I thought that my stock would not increase a lot, then I would sell it and buy a stock that I believe would increase a lot. Tomorrow I would write about another options strategy for generating income.
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