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This is how covered calls work in a nut shell: you own 100 shares of a stock, let’s say Microsoft which you bought at $30. You sell 1 option contract against this stock giving someone the right to buy the stock for $30 at the end of the month. For selling this right, you receive a premium of $1.35 or one hundred and thirty-five dollars total since each contract represents 100 shares of stock.
Important Note: 1 option contract = 100 shares of stock.
The buyer of the option is banking that Microsoft stock will increase over the coming month and be worth more than the $30 strike price of the option contract. If it is, their contract will have value since for example, if the stock goes to $31, they now have the right to buy it at $30.
The seller of the option contract is focusing on the cash flow that the premium is delivering. In this case the seller received a 4.5% rate of return on their money or $135 for the $3,000 investment.
Of course, the risk in this whole deal is that the stock drops like a rock. Of course, if you are already invested in single stock, then you are already here. You could combine Buffettology, the Buffett style of investing in which you purchase fundamentally sound companies with strong, consistent earnings, with covered calls. If you apply the Buffett method correctly then your stocks should appreciate over time
even if “Mr. Market” goes haywire. Again, if you are already in single stocks then you are already here. The difference is that now you will be writing covered calls against your stocks which decreases your cost basis in the stock while delivering cash flow.
Of course if you are in mutual funds then you are not at the same risk platform that I am recommending here. You will see that the technique I follow recommends that you diversify across sectors in a maximum of 20 stocks. This can get you closer to “mutual-fund” like investments and not the complete riskiness of non-Buffett single stocks, but remember, you will not be completely here since mutual funds can potentially hold hundreds of stocks.
Still, if you already hold stocks then you are already invested in stocks nonetheless then covered call options will not be much of a leap. If anything, they should make perfect sense to the cash flow investor since writing covered call options will now allow you to generate monthly income, much like rental property. Remember, your stocks are like little duplexes and the income derived from them via covered calls will more than likely beat your current returns through dividends and capital which gains which probably cap out at 10%. If you are as good as Warren Buffett then you should be able to generate a rate of return of 24%. Our method purports to beat this through covered call cash flow.
The following chart is the Covered Call Process Flowchart as presented by Joseph Hooper and Aaron Zalewski in their book Covered Calls and Leaps - A Wealth Option. I highly recommend you purchase this book and study this technique. Joe Hooper has been refining this methodology for over 30 years.
Where his method really excels is through the management of positions that “have not gone your way.” This is the whole crux of the plan because remember, the worst case scenario is that the stock drops like a stone. Hooper and Zalewski claim that through their system, you can continue to generate 3 to 6% a month in cash flow or 36% to 72% even if the stock drops. They have developed techniques, that will generate cash flow even if the stock is heading down.
The best analogy for this technique is found in rental property. If you have a four-plex that delivers $500 a month in cash at drops in price, say you purchased it for $150,000, the bottom drops out of the real estate market and it is now worth $75,000, but it still delivers the $500 a month in cash flow, would you sell it? If the $500 made your mortgage payment, would you sell the rental because the underlying asset price dropped in half?
The easy answer is no, correct? Many would argue that the real estate market is much less volatile than the stock market. Although recently, some real estate markets experienced drops of 50%, it is not likely that property is going to roller coaster like stock prices do. On average, property will make the slow climb at 4 to 6% a year. (can anyone say inflation?) Stocks on the other hand, are fairly manic depressive. Bad holiday retail season … market down. Decrease in the jobless number … market up … maybe, depending if analysts already factored this in. A company meets earnings … stock can decrease if analysts think they can’t do this again.
So you see, the market in many ways is ridiculous unlike, in theory, like the value of a piece of property which in general, in normal times, holds its value. The entire focus and the success of the Hooper/Zalewski plan relies on the ability to continue generating the same amount of cash flow regardless of the underlying value of the stock. This cash flow focus is the focus of our cash flow investing methodology which leads to financial independence.
Now Warren Buffett believes in ignoring the manic depressive nature of the market and buying into good companies with a solid history of earnings, a consumer monopoly or a toll bridge and the ability to reinvest those earnings and continue to compound them. Again, if you are an expert Buffett type investor, perhaps you just buy good companies that will increase in value over time and ignore the market.
I will go into detail on the individual decision points in the chart later but for now, here is the overview.
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