Now is the time for this advanced (but easy to use) strategy!

Writing covered calls is a strategy I’ve discussed here before, but I wanted you to know that I am now getting ready to actually start using it for my own dad’s income portfolio.

[Editor’s note: This is the same $100,000 account that Nilus shares with his Income Superstars subscribers.]

Why now?

Because, in its essence, covered call writing is a moderately bullish strategy. And in the case of an income portfolio, I actually think it works best if the market remains relatively flat or even pulls back a bit in the short-term.

So, yes, this means I’m less enthusiastic about more short-term market upside than the average analyst is right now.

In addition, options sell for the most money when the markets are volatile — and I think we’re going to see another pickup in wider swings over the next few months.

Remember, When You Write a Covered Call,
You’re Basically Trading Upside for Income

To understand why that is, let’s do a quick recap on the strategy.

Call options are contracts that allow investors to buy a given security at a given price (the “strike”) over a specified timeframe. Each options contract covers 100 shares of the security, known as a “round lot.”

Therefore, when we write a call we’re selling this right to someone else and collecting the premium — the price that the investor is willing to pay for the option — in return.

And the reason this is called covered call writing is because we are writing calls on stocks we own.

Yes, it is entirely possible to create and sell a call for a stock you don’t own, but I DO NOT recommend doing it. Known as “naked” writing, it literally leaves you exposed to lots and lots of risk.

Okay, so let’s say we write a covered call on 100 shares of stock we own.

What next?

As I already mentioned, we will first get the premium paid (minus commissions) deposited into our account. This is ours to keep no matter what.

Then, we wait and see what happens between now and the time the contract expires.

If the stock price fails to rise above the strike price of the contract, the investor who bought our call option will let it expire worthless. We get to keep our stake in the company, any dividends paid, plus the money we collected for the option.

The same is true if the stock goes nowhere or down during the life of the contract. And it’s even true if the stock temporarily goes above the strike price but the investor holding our option fails to exercise it.

Also, once the contract expires we would be free to write a new call with a new strike price and a new timeframe, which means we can continue collecting more and more premiums!

Meanwhile, the last possible scenario is that the stock rises above the strike price and the investor exercises the option before it expires.

In this case, we will be forced to sell our shares to the options holder AT the strike price. Please note that this is our only obligation. We can never be forced to sell the shares at any price other than the strike price!

In other words, the worst thing that can happen with covered call writing is that we will be forced to part with our shares for the predetermined strike price — which means we lose any additional upside from that point on.

But with covered call writing, we can never suffer any additional downside risk, as long as we pick strike prices that are higher than our entry prices plus commissions!

That makes covered call writing about as foolproof as a strategy can be.

Now, to actually do this in the real world, you first have to get your brokerage account authorized to write options.

Dad and I have already submitted his paperwork to Vanguard, and we should get approval shortly.

The process and time involved might vary a bit based on your broker, but essentially all you should have to do is fill out a form requesting “Level 1 Options” clearance. This allows you to write covered calls, and it is even allowed for IRAs.

A couple final points:

First, I only plan on writing contracts that are “out of the money.” In other words, we’re looking for strike prices that are HIGHER than the underlying stock’s current one — and CERTAINLY higher than the price we paid for the shares (including actual and potential commission costs)!

This is the only way to be sure that we won’t lose money on the covered call strategy.

Second, I will be recommending that dad place limit orders when he writes his covered calls. In other words, I will specify the lowest premium he should be willing to accept for a given contract, and we will use these parameters when submitting orders through Vanguard.

Third, assuming a contract gets written, we will obviously NOT be selling the underlying shares until the contract expires or is exercised.

Based on my preliminary calculations, following these simple rules should help dad earn even more money from his nest egg in the coming year … and I think it’s going to allow us to outperform the market once again in 2012.

I will definitely be sure to keep you posted about how the strategy actually works for us in the real world … and I encourage you to consider this approach for your own portfolio, too.

Best wishes,

Nilus

P.S. I plan on issuing the first covered call recommendations within the next month. So if you aren’t yet a subscriber to my Income Superstars newsletter, now is the perfect time to take a risk-free trial. Joining now will guarantee that you’re on board before we start this new approach … and will ensure that start getting advanced notice on ALL my specific trading ideas going forward.

P.P.S. I don’t think you’ll find another $39-a-year newsletter that has the kind of real-world track record and advanced approaches that Income Superstars offers!