Dividends are great. Just like receiving interest payments each month, dividends are passive income waiting to be credited to your account. The beauty is that you get paid no matter what you’re doing at the time — listening to the radio, traveling, working your regular job, etc; it doesn’t matter, you still receive the dividend. What is there not to like? Well, turns out there is another type of investment that behaves pretty much the same — covered calls.
A “call option” is an agreement between two investors. It gives the purchaser the right to buy stock, while the seller of the option then has the obligation to sell stock. Both parties agree in advance on the price (called the strike price) and on the duration of the option (options expire on a certain date, called the expiration date). The buyer of the option pays money (called ‘premium’, or ‘option premium’) to the option seller. If the buyer later decides he wants to exercise the right granted to him by the option, then the seller is required to sell the shares at the strike price.
As an example, let’s say Bob wants to buy 100 shares of XYZ for $50 between today (December) and three months from now. Bob buys one call option on XYZ stock with a strike price of 50 and an expiration date of March (for example). Let’s say XYZ is selling for $45 today and so Bob might pay $100 for the right to buy XYZ at $50 between now and March. He would do this because he thinks XYZ will rise above $50 between now and March. If XYZ shoots up to $60 then Bob can exercise his right and force the seller of the option to give him 100 shares of XYZ at the strike price ($50/share). Bob has to pay $5000 for these 100 shares. He can then turn around and sell the shares in the open market for $6000, pocketing $1000 (less the $100 in premium he paid to the seller when he bought the call option in December). However, if XYZ finishes below $50 in March then Bob’s option expires and he loses the $100 in premium.
Generating monthly income by selling covered calls to other investors is not difficult. If you do it with stocks you already own then the call options you are writing are ‘covered’ (because if the options you sold are exercised against you, you already have the stock you will need for delivery). If it happens that your stock is called away then you receive the strike price per share for your stock. If you still want to own the stock then you can either buy back the option before it expires, or wait until it is exercised and then use the proceeds to go into the open market and buy more shares to replace the ones you lost during exercise.
Covered calls are the most common option-based strategy (at many online brokers over 80% of the option-enabled accounts trade covered calls). Passive income accrues to you (the option seller) as time passes and the options you sold decay in value. If you’re not doing covered calls on stocks you own then you’re leaving money on the table. Why not have your assets work for you? The only requirement is that you own 100 shares of a stock or ETF; after that the rest is easy…
Born To Sell’s website offers more information about covered calls. To learn more about covered calls, visit Born To Sell.
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