Longtime readers of our newsletter know that we are strong advocates for creating reliable, passive investment income through dividend stocks. Recall that there are two main ways to receive a return on stocks on any investment. The first is to “buy low and sell high,” otherwise known as capital appreciation. Since every transaction involves two parties, you hope to purchase a stock you believe to be undervalued and later sell your shares to someone else at a higher price. The second way to receive a return on an investment is to purchase a stock that generates continuous cash flow to you in the form of dividend checks. The two combined: Capital Appreciation + Dividends = Total Return
In certain times, the capital appreciation portion will significantly outweigh the dividends because the stock price has increased substantially. When this happens, it may be prudent to sell your stock, “lock in” your total return and search for another opportunity. At other times, when the overall stock market is contracting, dividends may be the only positive contributor to your total return.
Perhaps it is time to add a third component to your total return stock equation.
Capital Appreciation + Dividends + Call Option Premiums = Total Return
This investment approach adds what’s known as a “covered call options strategy” to your portfolio. It is a way to generate more cash in exchange for future capital appreciation.
According to Schwab, “A covered call is when you sell someone else the right to purchase shares of a stock that you already own (hence “covered”), at a specified price (strike price), at any time on or before a specified date (expiration date). The payment you receive in exchange is called a premium, which you keep regardless of whether the call is exercised.
Yes, I know it sounds confusing, but you can read more about the details here: https://www.schwab.com/learn/story/options-strategies-covered-calls-covered-puts
But the best way to describe a covered call strategy is to think about real estate. If you purchase a condo as an investment property and rent it out to a tenant, you are doing so with the hope of creating an income stream in the form of rent checks and with the intent of selling that condo later for a price higher than what you purchased it at.
Now, if you also offered a “lease option agreement” to your tenant, you would essentially give the renter the right to purchase your condo (hence “covered”) at an agreed-upon higher price (strike price) at the end of the lease term (expiration date).
The renter will pay you a higher rental fee (premium) in exchange for the lease option agreement. If the condo never reaches the agreed-upon price (strike price), you get to keep the cash premium the renter paid you. But, if the condo exceeds that price, you will still have to sell it to the renter at the agreed-upon price.
Both with stock-covered call options and rental lease option agreements, the owner receives additional cash today in exchange for “capping” the capital appreciation potential of the asset. Not bad for someone who prefers a little more cash in their pocket to spend.
If you want to learn more about covered call strategies, please feel free to reach out.