How to Make Money by Laddering Covered Calls

How often have you wished for an investment strategy that bridged the gap between the stock market and income investments? Covered call writing is that strategy. Call writing is the most widely accessible option strategy. It can be utilized by any stock owner and does not include huge minimums or advanced analysis. However, in the stock market universe, it has been practiced by only a devoted few. You can be even more successful when you ladder your covered call writing.

Covered call writing will usually outperform stock ownership in any market except a strongly rising one. The investment landscape that can be expected over the next few years will be ideal for covered call writing. The price of stock options increase to their highest levels when market volatility rises. It is at these high volatility times when you can increase the premium you receive when selling calls as well as the increased downside protection for owning a stock.

I think of this as selling earthquake insurance as demand is highest right after an earthquake. This is the opposite of how it should be as demand should be highest when there hasn't been an earthquake in a long time. After all, stock options can be thought of as stock insurance to protect investors from unexpected price movements. We just had a stock earthquake and it is time to sell option insurance. The media has reported that Warren Buffett, the greatest investor of all time, is selling options in this market.

First, let's review how to setup a covered call holding. Covered call writing involves the sale of call options against shares of stock held in one's account. Call options of any available expiration month and strike price may be sold to create a covered write. The combined position can be any size with 1 call option covering 100 shares of stock. Therefore, if you own 300 shares of stock, you would sell 3 call options to be fully covered.

For example, you buy 100 shares of XYZ stock at $48.00 per share for a total of $4,800 excluding commission. Then, you sell a call at a strike price of $50 expiring the next month for a premium of $2.00. You now have received the $2.00 per share ($200 total for 100 shares) that lowers your cost to $4,600 ($4,800-200). But you have the obligation to sale XYZ at $50 anytime before the call option expires. If XYZ reaches or exceeds $50 before expiration, you will have the stock called away and receive $5,000. Since you have a total cost of only $4,600, you will make a profit of $400 in only one month. If XYZ stock is below $50.00 at expiration date, you will keep the stock and $2.00 premium. Then, you can sale your XYZ stock or sell another call for the next month to receive more income. You can repeat this cycle as long as the stock does not get called away when the stock price exceeds the option strike price.

Now, you know what a covered call is about and how to setup of the transaction. What is laddering? Laddering is a simple concept most often used with certificates of deposits (CD) and bonds. The idea in laddering is to smooth out the interest rate risk over several months. A 5-year bond ladder would consist of 5 purchases. One with a one year maturity, another at a two year maturity, then three, four, and five year maturities. After a year, the one year bond matures and you invest the proceeds into a new five year bond.

Laddering covered calls is a similar strategy but instead of smoothing interest rates you will be smoothing stock prices. The basic is that each purchase of a stock at a lower price will lower your cost basis. As you accumulate more shares at a lower price, you will be able to sell more calls for income. If you are called away, you will make a profit, and start the process over again.

You will start the process like you would with most covered call strategies but with an additional step. In the first month, you buy a stock and sell a covered call one strike price above the stock price and sell a cash-secured put at the strike price immediately below the stock price.

Why sell the put? You collect additional income for the month. If the stock price is above the put, you keep the income. If the stock price is below the put strike price, you buy more shares at a lower cost. The idea is to buy more shares the next month so the put automates the process and generates additional income.

In subsequent months, you will continue to buy shares and sell calls at one strike price above your average cost. With the put write, you are being paid to buy additional shares. The ideal situation is to buy no more than three purchases within a $5 range. The rationale is that if the stock price doesn't move much you are not buying at a lower cost. Once you reach three purchases, you can just sell puts at a lower price level to make additional income.

The goal with laddering covered calls is to manage downside risk, but it does not totally eliminate risk. If the stock price drops more than expected, sell calls on your lowest cost shares and then sell puts below the stock price. You should be prepared to hold shares from three months to a year. To be successful, focus on making income over the long term rather than fixate on short-term stock price movements. Remember, you are stepping down the ladder to manage downside risk when trading covered calls.