Covered Call
Covered Call
A popular strategy amongst investors looking to generate extra income from their portfolios is to sell a covered call option on stock that they already own in their investment portfolio. Selling covered calls can be a good way to generate regular income on stocks that do not even pay dividends (but you can use this income producing strategy on dividend stocks too).
First, lets look at how this strategy works. In this example, you own 100 shares of XYZ company in your investment account, it pays no dividend, and while you expect it to increase in price over time, it isn’t gaining in price very quickly, so you’d like to generate income with the stock until it hits your target sell price. To do this, you sell a covered call option contract against your 100 XYZ shares (your 100 shares “cover” the contract as collateral). In this scenario, somebody pays you cash that goes into your investment account, and no matter what happens next, the cash is yours to keep. The terms of the contract are very simple – you promise to sell your 100 shares of XYZ to the person who holds the contract at the price specified in the contract, by the date the contract expires – this last term is very important.
To continue our example, lets say XYZ company is currently selling for $20 per share, and you sell a call option using your 100 shares of XYZ stock as collateral with a strike price of $25, and a contract expiration date two months from now. You receive $1 per share for your covered call contract, or $100 total, which is deposited into your investment account. As long as the stock is less than $25 over the next two months, you will keep your stock, and the $100 you got for selling the contract. In this case, you will be able to to do the same thing again after two months, up to six times per year. In this example, you would be able to generate up to $600 in option income over the course of a year, from a stock that was just sitting in your online trading account.
What if the stock had risen above $25? In this case, you would most likely have to sell your stock to the covered option calls contract holder (this is done automatically by your online broker), for $25. So in this case, you would get the $25 per share for your stock, plus the original $1 per share that you kept from the sale of your option contract, for a total of $26 per share (or $6 per share gain from your $20 starting price) – not a bad profit for two months of risk in the stock market.
In order to execute this strategy, you will need to sign up with your stock broker to trade options in your account. This strategy is so so conservative, that many brokers actually allow you to sell covered call contracts in your retirement IRA account.