Creating regular cash flow from stocks
Typically, cash flow from stocks is derived from Dividends: a share of a company’s profits distributed to its shareholders. This is different from an increase in capital value, which is dependent on many factors such as economic performance, company decisions, broad investor sentiment, industry strengths etc.
US companies are not known for being high dividend payers. Their philosophy is that the company can reinvest its profits more successfully than you, the investor, can.
Compare that to a country such as Australia, where Blue Chip companies incentivise investors by paying regular dividends. Average figures can exceed 4.5% per annum, although individual companies regularly pay much higher.
For decades, however, investors have been adopting a strategy known as the Covered Call, to create an Income approach that provides consistency in cash flow. The strategy uses stock positions, and overlays Options (Exchange Traded Options or ETO’s) to create the position.
If you’re put off by the fact that Options are used, don’t be afraid!
This is a simplistic strategy.
If you’re not familiar with what Options are, then you can watch this quick video to help explain: <CLICK HERE>.
I’ll explain how the option fits into the strategy shortly.
The “Cash flow” aspect of the strategy is derived by selling the Call option against the stock position. You are receiving the premium of the option. If you were to do this on a regular basis, it would create a consistent return.
Now, there are numerous variations to how you can manage the strategy, and there is a little more to understand about the strategy. But the absolute basics are that selling the option contract creates a cash position that you would otherwise not have had by just holding the stock on its own.
As someone who has managed funds and private portfolios with this strategy for more than a decade, I have my preferred methods. But it pays to have an understanding of the most basic approach first, before considering alternatives.
How is the Covered Call created?
The Covered Call strategy is where you purchase shares, and sell the equivalent number of Call options against that stock position. You need to use your own capital to purchase the shares, but you receive the premium of the sold call options.
Adopting this strategy, the first rule of thumb is that you are not intending to hold shares for the long term. Your expectations are that you will sell your shares. And if you sell your shares, this will have been in a profitable position.
What we are doing by selling calls is to reduce our average buy price for the position. So, for example;
If you purchased 100 shares in XYZ at $30.00 per share, and sold 1 call option and received $0.60 per share in premium, your average price for the position would be $30.00 minus $0.60 = $29.40.
The benefit of entering this strategy, first and foremost, is that you reduce your average purchase price. The share price is then going to do one of three things: go up, go down, or go sideways.
- Should the share price fall, you are $0.60 better off than the person who merely bought the stock. And you will still hold your shares.
- Should the share price remain sideways, you have still received the premium and have a lower purchase price (as above). You may still be in a profit (depending on where the stock price is). Whereas, the investor has made or lost nothing.
- If the share price rises, then you will be “Called Away”, or Exercised, on the sold option. You will sell your 100 shares in XYZ. This is the nature of the strategy, and one of the reasons why a long-term investor shy’s away from the strategy.
If you would like to watch a quick video on how the Covered Call strategy works, CLICK HERE