Monthly Option Income Strategy

My Option Income Strategy generates monthly option premium income through the sale of ‘covered’ call options. The sale of the call option is covered by the underlying stock or by a long term LEAPS option making this a limited risk strategy. For novice option investors this strategy may be difficult to grasp initially but it is well worth the effort as this strategy has one of the best reward/risk ratios available and has been performing well during the recent volatile markets. 

I would like to focus on a trade I took today for Walters Inds symbol WLT. My brokerage confirmations below show that I purchased 1,000 shares of WLT stock for 67.41 points and sold 10 WLT May 70-Strike calls for 4.70 points. The May options expire in 6 weeks. This type of trade is also known as a ‘covered call’ or a ‘buy write’.

Walter Inds stock is currently in a price uptrend with its 50-Day EMA above the 100-Day EMA. We can see from the daily price chart below that the WLT 50-Day EMA which is the red line is above the 100-Day EMA which is depicted by the green line. I know from 24 years of historical testing of the price trend indicator that the most likely future price direction for WLT is up. Walter Inds also qualifies as a MVP  stock as it is making new 52-week highs and is in the coal mining industry which is currently one of the leading industry groups making it a good candidate for an Income Strategy trade.

If Walter Inds closes at or above 70.0 at option expiration then the full profit potential of 7.29 points or $729 will be realized on this trade. The cost of this stock/option spread is 62.71 points and is calculated by subtracting the 4.70 points received for the sale of the 70-Strike call option from the 67.41 point stock purchase. A $729 profit would represent an 11.6% return at May option expiration on the $6,271 cost of the spread (before commissions). An 11.6% return over this time period equates to a 109% annualized return.

The profit/loss for the WLT covered call trade is determined by the price of WLT stock at May option expiration. The covered call analysis table that follows displays the profit/loss for the trade assuming various prices of WLT stock at option expiration.

The first row of the table is labeled ‘% Change’ and assumes various percent changes in WLT stock at option expiration from a 10% increase in price to a -10% decline in price. The second row is labeled ‘Stock Price’ and is the WLT stock price that corresponds to the percentage change on the row above. The third row labeled ‘Stock Profit or Loss’ lists the corresponding dollar profit/loss for a 100 share purchase of WLT stock related to the price change in the stock. The fourth row displays the short call value and the fifth row displays the corresponding dollar profit/loss for the short call related to the price change in WLT stock. The sixth row displays the overall dollar net profit/loss for the spread and the last row displays the % return for the trade.

The analysis shows that this covered call trade provides profits if WLT stock goes up in price, remains flat or is slightly down at option expiration in one month. If WLT stock remains flat at 67.41 at option expiration, a $470 profit will be realized (circled). This translates to a 7.5% return on the $6,741 cost of the spread. A 2.5% increase in WLT stock to 69.10 would result in a $639 profit and 10.2% return at option expiration. The profit potential for covered call trades is limited once the stock increases above the strike price of the call option sold. In this example our profit is limited to $729 regardless of how high WLT stock increases above 70.0 at option expiration.

A 7.5% monthly return for a stock that is flat is a great return for such a low risk strategy. A 5% decline in WLT stock would result in a 2.1% profit for the covered call trade and a 10% decline in WLT stock would result in a 3.3% loss for the covered call trade. The monthly covered call strategy can provide an excellent return in relation to risk.