Selling Out Of The Money Covered Calls

In a situation like we have now in the market there are many stocks that are way undervalued.  You may be looking into buying some of these undervalued stocks and waiting for the market to recover.  If so selling out of the money covered calls on those stocks is an excellent way to generate monthly cash flow from your investments.

When you sell out of the money covered calls on a stock you are generating an income by selling the right to buy your stock at a certain price on or before a given strike price.  So you limit your potential profits, but rake up a nice premium in the process.

Buying undervalued stocks and selling covered calls on them can be an excellent strategy that investors like Warren Buffet have used to generate above average return. Let’s look at an example, stock XYZ is trading at $12, you believe that the stock should be trading at $20 fundamentally.  Instead of buying the stock and waiting for it to get to $20 you can.

1.       Buy the stock at $12

2.       Sell a  $20 call 3 or 4 months out

3.       Collect a premium on that call, say $.80

Now you wait to see what happens, if the stock goes up to $20 or further within that timeframe you will be forced to sell your stock at $20.  But that still is an $8.8 or 73% gain in 3 or 4 months.

The more likely thing that would happen in a case like this would be that the stock does not go above $20 in that time frame.  In this case you make $.80 from the call or 6.6% plus or minus whatever the stock did during that time.

Remember that selling far out of the many calls should not be a strategy on its own but another way to pull out money from your long term stocks that you already have, or you are getting into. 

For more information about covered calls visit http://www.stocks-simplified.com/covered_calls.html