Let's evaluate how using covered calls can boost your returns.

Using a covered call strategy can be an effective way to boost your monthly income on your dividend growth stocks. It is a relatively safe way to earn additional income on your investments while protecting potential downside risk. Let’s dig into the best stocks for covered call writing.

Best Stocks for Covered Call Writing (Including Two Dividend Stock Examples)

With the market enjoying a tremendous run since the 2009 bottom, investors would be forgiven for wondering if the good times will continue or if we might be set for a multi-year period of flat or negative returns.

One way to deal with this possibility is by structuring our portfolios to be more focused on income generation rather than growth.

One of the best strategies for generating income is covered call. They are one of the easiest to understand and implement option strategies and they perform very well in flat, slightly up and slightly down markets.

When you combine covered calls with dividend stocks, the results can be very impressive indeed. If you are still thinking about how to invest in dividend growth stocks, review our guide on building a dividend growth stock portfolio.

I love using FINVIZ and FINVIZ Futures to make better decisions about my covered call strategy. Check out how to use FINVIZ futures to understand market trends.

Covered calls are a reasonably low risk way for investors to get started with options. There is a natural progression for an investor who is already accustomed to share ownership to begin to explore the fabulous world of covered calls. The key is to educate yourself, and practice, practice, practice.

Covered calls are not something you learn about in school. In fact, schools don’t really teach you anything about personal finance or investing. This is one of the great failings of our education system. Someday, I hope I can help rectify that.

Covered calls are one of the greatest wealth creation tools you can find. A covered call can protect your downside risk on your investment and help you earn additional income. I love investing in dividend growth stocks and deploying a covered call strategy to earn additional monthly income.

In addition, I pair FINVIZ with my commission-free Robinhood dividend growth stock account.

Robinhood offers completely commission-free options trading. I couldn’t believe it when I saw it. That is very rare considering options trading is viewed as a premium product for brokerage accounts.

You can check out our Robinhood app review and how the Robinhood dividends work in our Robinhood app guide.

What are covered calls?

A covered call is a financial transaction in which the seller of call options owns the corresponding amount of the underlying investment, such as shares of common stock. If an investor is invest in a stock, the long position in the shares of common stock provide a “cover” as the shares can be delivered to the buyer if exercised.

Writing (i.e. selling) a call generates income in the form of the premium paid by the option buyer. And if the stock price remains stable or increases, then the writer will be able to keep this income as a profit, even though the profit may have been higher if no call were written. The risk of stock ownership is not eliminated. If the stock price declines, then the net position will likely lose money.

Example of writing covered calls with dividend growth stocks

Let’s look at an example to help you understand how writing covered calls can help you boost your investment returns.

XYZ stock is trading at $100. You own the stock and don’t think it’s going much higher. You want to increase your income potential so you decide to sell a call option with a strike price of $100.

The buyer of the option, takes the other side of your trade and is bullish on the stock. They think it’s going up beyond $100.

For the right to buy the stock for $100, the option buyer pays you a premium of $5.

Let’s look at some scenarios…

Scenario #1: Stock goes to $85

The buyer of the option will walk away and lose 100% of his $5 investment. You will still own the stock, but are sitting on a loss of $10 which is better than the $15 loss you would have if you hadn’t sold the call option.

Scenario #2: Stock stays at $100

The buyer of the option will walk away and lose 100% of his $5 investment. In theory he could exercise the option if he wants to own the shares, but it is easier to just buy them directly in the market. Note: Most brokers will automatically exercise an option if it is 1 cent in the money. So, if the stock closes at $100.01 the option would be automatically exercised.

You are happy because you have made a $5 return on a stock that has gone sideways thanks to the option premium.

Stock goes to $105

The option buyer will either exercise his option and buy the shares for $100 or sell the option in the open market. If he buys the shares for $100, he can turn around and sell them in the market for a $5 gain. But, he paid $5 for the option, so his profit is zero.

Alternatively, he can sell his option for $5 in the open market. Either way, he has made a breakeven trade.

You are happy because you have made a 5% return, the same as if you had just held the stock..

Stock goes to $115

 If the stock goes to $115, both investors are happy, although you are a bit disappointed you didn’t just hold the shares outright. You still make your $5 profit and 5% return, but you have left another $10 on the table.

The option buyer is happy because he can purchase a $115 stock for only $100 (don’t forget he also paid the $5 in premium, so his total cost is $105). Or he can sell the option for $15. That’s a $10 profit on a $5 investment.

The table below shows the outcome for each investor at different stock prices. Remember to multiply these amounts by 100 given that each option contract controls 100 shares.

Example of call buyer returns

Best Stocks for Covered Call Writing

The best stocks for writing calls are the following:

1. Stocks that pay a dividend
2. In addition, write covered calls on stocks that have suppressed valuations that haven’t yet unlocked value
   • For example, General Motors was highly undervalued and the stock took significant time before it started to increase in share price. People just did not believe that General Motors was actually growing or generating strong cash flow. During that time, the stock was stuck in a trading pattern of about $36-$40 for a number of years. That’s a lot of covered call writing! The stock eventually increased by about 15-20% after earnings calls.
3. Write a covered call on a stock in between any significant events. We don’t want increased volatility. In fact, we’d prefer for volatility to be high but expected to decrease. Thus, leading to a decrease in the extrinsic value of the option and you earning more money!

Hope these points helped you identify the best stocks for writing covered calls. With that being said, let’s get into two of the best stocks for writing covered calls in 2018.

Two of the best stocks for covered call writing in today’s market

XOM – EXXON MOBIL CORPORATION

XOM has trade between $72 and $88 over the past two years and is currently in the middle of that zone around $80.

The dividend yield on XOM is currently 4.07% which is a healthy income, but investors that want to improve the income potential, can sell covered calls.

XOM – ExxonMobil Dividend Growth Stock Chart

Investors who own 100 shares of the stock could sell an August 17^th $82.50 call option for $1.81/share.

If XOM stays below $82.50 at expiry, the call option expires worthless and the investor achieves $2.63 in income, for a return of 3.26% which is 16.50% annualized.

In addition, if XOM rises above $82.50 at expiry the investor gains another $1.72 in capital gains for a total return of 5.38% which is 27.30% annualized. Not a bad return! That makes this a one of the best stocks for covered call writing.

If XOM drops, the investors break even price is reduced by the option premium and the dividend received and is therefore $78.15.

XOM – ExxonMobil Covered Call Returns

KHC – THE KRAFT HEINZ COMPANY

KHC’s shares have been decimated in the last 12 months falling from $90 to as low as $53.54.

The chart below is certainly not a pretty picture, but some investors may see value there.

One positive of the declining stock price is a very tasty (pardon the pun) dividend yield, which currently sits at 4.32%.

KHC – KraftHeinz Dividend Growth Stock Chart

Investors looking to boost the income on this stock could sell a covered call using the October 19^th $60 calls which can be sold for $2.20/share.

If KHC stays below $60 at expiry, the call option expires worthless and the investor achieves $2.83 in income, for a return of 4.88% which is 13.19% annualized.

Then, if KHC rises above $60 at expiry the investor gains another $2.08 in capital gains for a total return of 8.47% which is 22.90% annualized. Making Kraft-Heinz stock another one of the best stocks for covered call writing.

If KHC drops, the investors break-even price is reduced by the option premium and the dividend receive, which is $55.10.

KHC – KraftHeinz Covered Call Returns

Options trading can be risky (and scary) for newbies, but when used correctly they can be a valuable addition to a portfolio. Investors looking to increase the yield portion of their portfolio would be wise to add covered calls to their stock holdings provided they don’t mind giving up some potential capital gains.

What are the best stocks for covered call writing in your opinion? I’d love to hear from you in the comments below.