This Trade Could Deliver an 11.1% Yield
Readers know I’m a big fan of exploiting “covered calls” to earn safe, double-digit yields.
In previous essays, I’ve shown how to harness this technique to earn income streams of anywhere from 10% to even 15%. These payouts represent a godsend for retirees, who thought they had to settle for the tiny yields on bonds and certificates of deposit.
Today’s trade idea comes from Chevron Corporation (NYSE:CVX), one of the world’s largest oil drillers. Right now, shares yield only 4.1%. But by using the covered call method, we can nearly triple our income.
Here’s how.
As the time of this writing, CVX stock sells for $106.50 per share. The October 20 $110.00 calls change hands for about $1.25 per share.
Our trade involves buying 100 shares of CVX stock and selling one of those call options at the same time. By selling the call option, you give the buyer the right to purchase your 100 shares at $110.00 anytime before October 20. In exchange, you receive a $1.25-per-share payment.
On October 20, this trade can work out in one of two ways:
Outcome #1: CVX stock trades under $110.00. Your options contract expires and you keep your shares. In the process, you earn a $125.00 premium ($1.25 x 100 shares). Excluding any fees, you receive a 1.2% yield for selling the covered calls ($1.25/$106.50) in 60 days. On an annualized basis, that works out to a yield of seven percent.
Outcome #2: CVX stock trades over $110.00. Our 100 shares will get sold at $110.00. In this scenario, you still collect a $125.00 premium ($1.25 x 100 shares). And because you’re selling your shares at a profit, you also earn a $350.00 capital gain. In this outcome, our total profit tops out at $475.00. In percentages, that represents an instant 1.2% yield for selling covered call ($1.25/ $106.50) and a 3.2% return from capital gains ($3.50/$106.50).
In both cases, you earn a lot more income than from dividends alone. If you replete this trade each time your options expire, you earn an extra seven percent yield in premiums. On top of the dividend from Chevron stock, your total yield jumps to 11.1%.
The downside? If CVX stock shoots through the roof, our upside gets capped at $110.00. And if shares plunge, you’re stuck holding the bag.
For this reason, I’d only make this trade if 1) you want to own Chevron stock anyways, 2) you’re comfortable holding on for the long-haul in case shares drop, and 3) you’re okay letting it go if shares get called away.
Speculators might not like this deal, but for income investors, that trade-off makes sense. They don’t mind giving away some of the market’s upside in exchange for safer, surer yields today.
Here’s how I would make this trade…
Option contracts work in 100-share blocks. That means we need to own at least 100 shares of Chevron stock to begin trading covered calls. For every 100 shares I own, I would “Sell to Open” one option contract. And to avoid getting ripped off by market makers, I always use limit orders. Accounting for the $125.00 in premiums collected at the beginning, this trades requires at least $10,525 of investment capital.
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