Options, options, options—we all love having options. Therefore, we should all learn how to trade options on the stock market. Learning to trade options is part of our bigger plan to diversify our passive income.
First, a quick disclaimer. This article will not give you an exact science or step-by-step guide to selling covered calls. I will refer you to a couple of books that will help you along your path if you like what you read.
Even those books may not be enough to teach you exactly how to trade options. I watched a YouTube video to learn how to conduct the step-by-step tutorial on trading a covered call on Charles Schwab. Options are complex, so be warned. I am giving you an idea of why options are vital to our long-term passive income goals.
Don’t Gamble Your Retirement Away 4
Speaking of long-term passive income goals, let’s take a bird’s eye view of retirement as an average person (that’s us). To build our happy cash flow retirement system, we will use the combination of retirement income, investing, cryptos, real estate, and business.
Under the investing pillar, we have dividends, interest, commodities, and gold (& silver). Once we have a large enough dividend portfolio, we can trade options to increase or supplement our dividend income.
Let’s talk a little bit about options before we get into the philosophy of trading covered calls. Options give the buyer the right to buy or sell the underlying stock or asset, not the obligation.
Buying a call option gives the buyer the right to buy the underlying stock from the seller. Buying a put option gives the buyer the right to sell the underlying stock to the seller.
When you are the seller of options contracts, you are in the insurance game. You are giving the buyer some form of insurance to perform whatever move they are attempting in the stock market.
The first book we should read is called “The Options Playbook.” It gives a nice history of options and also many different options plays. It is good to have an extensive overview of options trading before drilling down into our specific techniques.
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Now, do not fear if buying and selling options sound confusing—it is off-putting. It is very different from buying stock or shorting stocks. Since options are so confusing, they can be dangerous for new traders like us.
Therefore, our brokerages have put safety mechanisms in place to protect us from harm. The first of which is having options trading levels that we must qualify for first. Each options play (or technique) requires a skill level.
To conduct our play, our brokerage must qualify us to make this play under our options level. Trading covered calls require a level 0 trading account on Charles Schwab. Even though it is the lowest level, you still have to request permission to access options trading. I was able to qualify as a level 0 options trader.
Now let’s get into the overview of trading covered calls. I highly recommend you read the excellent “Covered Calls for Beginners” for a very in-depth look at covered calls. I plan on reading an in-depth book for every play I want to learn. Options trading has many benefits, but we have to take it seriously and conduct due diligence.
Do I Need Lots of Money to Start Investing?
Selling a covered call means selling insurance to the buyer while you own the underlying stocks. One option contract consists of 100 shares of the underlying stock. Since you own the 100 shares, you are “covered” if the buyer exercises the contract.
Two important terms are the “strike price” and “in the money.” The strike price is the agreed-upon price that the option will be “in the money.” We will get into these as we progress. I think it’s prudent to give an example to dissect it as we dig deeper. Don’t worry if this is confusing; it took many more months and a few books to wrap my brain around options. Remember to keep a growth mindset vs. a fixed mindset. A growth mindset allows us to learn, even when things seem difficult.
We own 100 shares of AT&T (T) stock. The current price of T is $28. Let’s say T has been range-bound between $27 and $30 for over two months. We are not expecting any major news in the upcoming 30 days.
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We decide to sell a covered call with a strike price of $30. As long-term investors, we do not want to lose our stock; we want to collect the premium and let the option contract expire worthless. That is why we can sell covered calls for passive income. I’ll discuss this more after the example.
This chart may confuse you; however, we see that the strike price of $30 offers us a price range of $0.04 and $0.05 a share. We can offer to sell our call at $0.04/share for a total of a $4 premium. We can also see that there is 367 “open interest” in this call—so there is liquidity there.
We sell our covered call for $4 minus the broker’s fee, and then we wait 26 days for it to expire—hopefully worthless. If all goes as planned, we keep our premium (we keep our premium no matter what), and we do the same covered call next month.
Now, let’s dig more into the mindset of selling covered calls for passive income. First, we need to own plenty of shares in our blue-chip stocks. Those are the stocks we should be trading options with monthly because high-flying stocks or growth stocks, like Draftkings or Palantir, move up and down at incredible speeds. Here is a list of my 24 favorite blue-chip stocks; there are many more than those I list.
We can safely sell covered calls once we have enough shares in our blue-chip stocks, say 400-500. First, we want to look at the 3-6 month chart of our blue-chip stock to see its trading range. We want to assign a strike price that will allow us to keep our premium and our stocks safely.
Do not get greedy with the strike price. As you can see, the closer to being “in the money,” the more premium we can collect. This extra premium can be tempting, but we need to think as long-term investors and protect our stocks at all costs.
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Why are buyers buying insurance? It is good to know the rationale of the buyers as well. Most likely, the buyer of the call is expecting the stock to make a significant jump in price during the move towards the expiration date.
In our example above, the buyer may think that the T stock will move to $33 or $34. If the price moves that high, they can either sell the contract for a profit or collect the stock and sell the stock for a profit.
Whatever the buyer’s intent, we, as sellers, want to collect our premium safely. Now, what does this $4 premium do for our overall yield? Let’s say AT&T yields 7.55% annually. Each share currently pays us $2.08. That means our 100 shares would produce us $208 annually.
If we collected our premiums safely each month, at $4 per contract, that would give us $48 in insurance premiums (minus broker fees). We can then add that $48 to the $208 of dividend income we receive, for a total of $256. Our total yield increases from 7.55% to 9.29%.
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If you are confused, that is okay. It takes a while to wrap your head around these concepts. If they were simple, everyone would trade options. Let’s review how we could use options on the path to living our dream laptop life.
Options will increase the yield of our blue-chip stocks by forcing “synthetic dividends.” Trading options and selling covered calls is a safe way to collect premiums. The worst that can happen is that the stock crosses the strike price, and our stocks get called.
We can trade options from anywhere in the world so that we can certify them for laptop life. The hardest part, once we understand covered calls, is to remain consistent. We do not want to get greedy with the strike price. We want to collect our premiums safely and repeat the trading process next month. That is how we continue to build wealth, month after month.
Did you understand the purpose of selling covered calls? Do you want to read more about options? I recently read a book about selling cash-secured puts to buy dividend champion stocks. I will write an article about that technique next time. Enjoy and Happy Investing.
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Disclosure: I am not a financial advisor or money manager, and any knowledge is given as guidance and not direct actionable investment advice. I am an Amazon Affiliate. Please research any investment vehicles that are being considered. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. All Right Reserved Military Family Investing
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