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Get More Out Of Your IRA With Covered Calls

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Get More Out Of Your IRA With Covered Calls

If you’re looking for a thing to increase your IRA income, writing covered calls may be the answer for you. 

The practice is considered reasonably conservative, very low risk, and often generates a certain amount of income regardless of how slow a stock appreciates.

What is a Covered Call?

iraA covered call (or buy-write) is a contract that grants the buyer the option—but not the requirement—to buy a hundred shares of a particular stock at a pre-fixed price at any point before the contract expires. 

This pre-fixed price is known as the strike price.

The buyer pays a premium for the contract, and the owner of the stock keeps this premium regardless of whether the buyer chooses to call, that is, buy the stock.  

If the price of the stock goes above the strike price before the contract expires, the buyer benefits as he or she can buy at a lower price than the general market.

If the price goes down or stays the same, the buyer will often abandon the contract unfulfilled, meaning that the seller both pockets the premium and keeps the stock. 

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However, even if the price goes up and the buyer calls, the worst that can happen to the seller is that their profit is capped below the market’s ultimate high. 

This is why the practice is considered conservative and as safe as any option can be.

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A Graph Illustrating Covered Calls

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The blue line represents changes in the S&P 500 Index while the purple line shows the relative profit in a covered call written against the S&P 500. 

As you can see, the premium paid for the contract softens the dip at the bottom, while the strike price limits the profit at the top.

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So How Does it Work in Practical Terms?

Let’s say that you own 500 shares in Blue Buffalo, which for the sake of example is flat-lining at $20 a share. 

You think it will continue to stay where it is, but your friend believes the price will go up. 

So you and your friend strike up a deal.

You write five calls for $25 a share which your friend accepts at a premium of $2 per share since she is so confident that Blue Buffalo will rise from the ashes. 

Already, you have made $1000 in premiums, and the contract lasts six months. 

What happens next depends on what the stock market does.

What If the Stock Stays the Same?

If the stock stays the same for six months, your friend will probably not exercise her option to buy. 

Thus, you keep your 500 shares that are worth $20 a piece and keep the $1000 in premiums that your friend paid to you. 

Clearly, you come out a winner in this scenario.

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As illustrated by this chart comparing profits on no covered call versus uncalled shares, your friend will be out the thousand dollar premium, which becomes a marginal profit for you.

What if the Shares Skyrocket?

Instead, say that four months into the contract, Blue Buffalo is suddenly worth $40 per share. 

Your friend calls the stock and only has to pay you $25 a share for it. 

She turns around and sells on the market at a profit of $15 over 500 stocks—for a total profit of $6500 when you subtract the thousand she gave you in premiums at the beginning of the contract.

Had you not entered into the contract with her, each of your 500 $20 shares would now be worth $40, meaning you could sell them for $20,000. 

In this regard, you did not win. 

However, you still kept the $1000 premium and made $12,500 off the sale of the shares.

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As you can see from this chart comparing no covered call to shares which grew and were then called, while you make less with called shares, you make far from nothing. 

Furthermore, your friend’s chance of turning the profit shown is what will motivate her to enter into the contract with you to begin with.

What are the Disadvantages to Covered Call Writing?

  • There is always the risk of having to sell your stock at below market value
  • There may be applicable transaction fees
  • The actual sale of the stock counts as a reportable transaction for tax purposes.
  • As with all options, there is still some risk involved, and some expertise is recommended.

What are the Advantages to Covered Call Writing?

  • It allows you to make money off of your stocks even when the market is not cooperating.
  • Premiums can add up very quickly if one makes enough of them.

So Why Apply This Method to your IRA?

In the same way as writing covered calls can generate income on stocks that are not growing, writing covered calls for your IRA can generate additional income. 

Many brokers allow them, and the tax rules tend to be different should the stock be called.  All in all, it’s win-win.

To call it up

Once you develop a solid understanding of covered calls, they are reasonably safe and a good way to generate extra income on your IRA. 

You may be surprised by how much extra you can put away, and when it comes to retirement, you want to put away everything you can get.

 

 

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