Cash Flow Trader Blog: The Ultimate Dividend Part 4
Step #3: Selling Covered Call Options Against Your Stock
Now that we own the stock, we can execute a favorite strategy among investors. This is called selling covered calls, and here is how it works: each month, you sell a call option at a price you would be happy to sell the stock at. That is it.
When you sell a call option, you give the buyer the right to buy the stock from you at a specific price called the strike price. Each month, if the stock is trading below the strike price by the time the option expires, then the option expires worthless, and you get to keep the money you made for selling the contract, which is called the “premium.”
Collecting Rent on Your Stocks
Remember, covered means you own the stock that underlies the options contract. So selling covered call options is just like renting out a house you own. Each month, the tenant will pay you rent to use your house, and in a rent-to-own deal, eventually, the tenant might buy the whole house from you. We are doing the same thing with our stock. Each month, we are “renting it out” to someone else. We still own the stock; it is still in our account, just like we own the house we are renting out.
Eventually, if the stock goes up enough, someone else can buy it from us. In that case, we book a profit on the stock, and we still get to keep the premium we received for selling options on our stock. Then, we can take our winnings and repeat the entire process on another stock.
If no one ever buys our stock, then we keep collecting premiums every month and dividends every quarter or as often as the company pays dividends. Some people prefer to buy stocks that pay monthly dividends, so their payments line up nicely, and the cash register keeps ringing every month.
Picking the Best Call Option
Just like with selling put options to get into our position, there are some criteria to follow when selling call options to cash flow our position:
- Again, I recommend selling monthly options, aiming for the next monthly options that expire in 15-45 days.
The farther away the expiration date is, the more premium you will receive for selling the contract, but the higher risk that the stock goes up a lot by expiration and you have to sell your shares.
- Sell the strike price that you’re happy to sell the underlying shares at.
Going back to our previous example, if I could buy TRP stock for $40/share, I might be happy selling them at $50/share to sell the 50-strike call options. If the stock goes up and I have to sell my shares, I will receive $10 per share in profit, plus I get to keep the premium I received for selling the call option.
- I recommend selling at least 1-2 strikes Out Of The Money (OTM).
That means, if the stock is trading at $42/share and the strikes of the options are in $5 increments, I would consider selling the $45 or $50 strike calls. Again: I strongly recommend against selling In The Money (ITM) options!
Maximizing Premium
Like selling put options, many factors will influence the premium you receive for selling call options. They all carry a balance of risk and reward. The further out you sell a call option, the more premium you will receive, but the higher risk that the stock will move past the strike price by expiration.
Similarly, if you sell a call option with a strike price very close to the stock’s current market price, you will receive more premium, but the stock doesn’t have to move much for your stock to be called away at expiration. If volatility goes up, options will all go up in price—which means you’ll receive more premium for selling them, but also that there’s a higher likelihood the stock will move a lot before expiration.
The Ultimate Dividend Strategy Recap
In summary, the Ultimate Dividend is an excellent strategy for cash flowing your trading account. It is a three-pronged strategy that brings in money every month, regardless of the stock market. It allows you to be agnostic about market moves while still putting cash in your jeans month in and month out.
All you have to do is first find a great dividend-paying stock. Then, sell a put option every month until you can buy the stock at a great price. Once you have bought the stock, you can “rent it out” by selling a call option against it every month until the stock gets called away and you sell it for a profit. And if you own the stock over its ex-dividend date, you will continue to reap the dividends as well. It’s the ultimate strategy for cash flowing into your trading account.
