Covered option calls are a popular way to generate recurring investment income in an investment portfolio, even in retirement portfolios like Individual Retirement Accounts (IRA’s).  This income can be generated on any stock in your portfolio that has actively traded options associated with it, the caveat being that you need to own at least 100 shares of the stock you are going to sell covered option calls against in order to take advantage of this money making strategy.

Let’s start by looking at what a call option is.  A call option contract gives the buyer the right, but not the obligation, to buy 100 shares of stock at the price defined in the contract (strike price), on or before the date the contract expires (expiration date).  One of the key concepts here is that the buyer of the covered option call contract would lose money if they exercised their right to buy the stock, if the stock is trading below the strike price of the contract.  This is simply because they could buy the stock for a lower price on the open market, so there would be no point in exercising the call option contract under these circumstances.

In order to implement this income producing strategy, an investor will have to do a couple of simple tasks.  First, the investor would have to ask their broker to set up their trading account to allow options trading.  This usually involves reading a short pamphlet on the risks associated with standardized options trading, and signing a form indicating that you understand the risks.  The investor will probably also have to tell the broker what options trades they want to be approved for, and their risk tolerance for these types of trades.  As I indicated earlier, this strategy is so conservative, most stock brokers will even let you do it in your IRA account.

Next, the investor must identify which stocks they would like to sell options against.  These stocks can have options sold against them in 100 share multiples, since each contract represents 100 shares.  For example, if you own 230 shares of Apple (AAPL) in your account, you could write 2 covered option calls contracts against 200 shares of the Apple computer stock in your account.  Finally, the investor needs to determine what price they would be like to write the contract for, and how long they would like the contract to be in place.

Once the investor has completed these steps, they merely need to call their broker (or login to their online trading account), and place the order to sell the covered option calls from their account.  Once the sale is complete, the investor will receive cash in their account for the call options that they sold – this cash is theirs to keep.

If, at the end of the contract period, the price of the stock is below the call option strike price, then the investor keeps their stock, and can write new covered option calls against their shares of stock.  However, if the stock price has risen above the strike price of the option contract, then the investor will have to sell his shares to the contract holder at the strike price specified in the agreement.

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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.

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Stocks That Pay Dividends

Stocks that pay dividends can be a good alternative for investors either seeking regular income from their investment portfolio, or more consistent returns from their stock investments.  An investment in stocks that produce consistent dividends can be an ongoing source of profits for your portfolio.  These are some of the characteristics that these income producing investments provide:

1. Stocks that pay dividends can represent a single company, or they can be many companies under the organizational structure of a holding company, trust, closed end mutual fund, ETF, etc.  It is important to note that a majority of companies do not qualify for dividend investing for the simple reason that they do not pay dividends.
2. Companies that pay dividends do so because their management teams and boards of directors make a conscious, regular, and most importantly – discretionary – decision to pay their shareholders a dividend.  While most companies do this quarterly, there are many stocks that pay monthly dividends.
3. Dividend stocks typically have policies in place that promote the ongoing payment of dividends.  So while the decision to pay a dividend is at the discretion of the management team and board of directors, they typically have a goal of managing the company in a way that preserves, protects, and in many cases, grows the dividend income streams for their shareholders over time.
4. In many cases, stocks that pay dividends represent companies that are large, and more established (i.e. they have been around for a while).  These companies have created consistent, stable cash flows with very predictable earnings.  For example, utilities are a great type of stock that pays a dividend, they have a steady, predictable, source of income, expenses that are understood (and that can usually be passed along to their customers if expenses go up unexpectedly), which leads to a stable source of profits to pay dividends with.
5. Stocks in general are volatile, but stocks that pay dividends are usually lower in volatility than the overall stock market.  This is because investors are confident enough in the earnings of these companies, and the income they produce on a regular basis for their shareholders, that they reward this stability with lower price volatility, due to the justified view that these stocks are safer than average.
6. There are also tax advantages to owning dividend paying stocks.  Capital gains only trigger a taxable event when these stocks are sold, just like regular stocks.  The key tax advantage is that right now, the maximum federal income tax rate for dividends is only 15%.  This tax rate is lower than the tax rate you pay on bond interest, which is usually taxed at the same rate as your salary.  15% is typically much lower than your marginal tax rate for other sources of income.

As you can see, stocks that pay dividends have characteristics that set them apart from the overall stock market.  These income producing stocks may have a place in your investment portfolio.

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