Jump Start Your Recurring Income With Covered Calls
Dividends are great. Just like receiving interest each month, dividends are passive income waiting to be credited to your account. The nice thing is that you get paid no matter what you’re doing at the time — watching TV, traveling, working your regular job, etc; it doesn’t matter, you still receive the dividend. What’s not to like? Well, turns out there is another type of investment that behaves pretty much the same — covered calls.
To understand covered calls, we first need to understand calls. A “call option” is an investment product that gives the purchaser the right to purchase stock for a known price (called the strike price) on or before a certain date (called the expiration date). In exchange for this right the buyer pays ‘premium’ (money) to the option seller. If the buyer decides he wants to exercise the right granted to him by the option, then the seller must sell the shares at the strike price (the seller also gets to keep the option premium he received at the beginning of this trade).
Let’s look at a covered call. Imagine Andy is bullish on Acme Industries. He would like to purchase 100 shares of Acme Industries for $30 between today (April) and three months from now, but he doesn’t have enough money to buy 100 shares. So instead, Andy buys one call option on Acme Industries stock with a strike price of 30 that expires in July. Let’s say Acme Industries is trading for $27 today, and let’s say Andy pays $100 for the right to buy Acme Industries at $30 between now and July. He would do this because he believes Acme Industries will rise above $30 between now and July. If Acme Industries rises to $40 then Andy will exercise his right and require the seller of the option to sell him 100 shares of Acme Industries at the agreed upon strike price ($30/share). Andy will have to pay $3000 for the 100 shares, but he can then sell the shares in the open market for $4000 (the same day), pocketing $1000 (less the $100 in premium he paid to the seller when he bought the call option in April).
Selling call options to other people is a good way to earn recurring income. However, you only want to do it with stocks you already own. That way if the options you sold are exercised you already own the stock needed to deliver your end of the deal. That’s why it’s called a ‘covered call’… your obligation is covered by the stock you own at the time you sell the call option. If your stock is called away then the worst that happens is you receive the strike price per share for every share covered by the option (and you can set the strike price as high as you like when you sell the option).
Using covered calls to create recurring income is common (in fact, it is the most popular option-based strategy). It is a passive income strategy that lets you collect option premium each month as time goes by. If an option buyer exercises the option the only thing that happens is that he will pay you for your stock. You still make money. Another nice feature is that the option premium you collect each month gives you current income as well as some downside protection. Covered calls are easy to learn and execute and should be done by anyone who owns stocks or ETFs. If you’re not doing it then you’re leaving money on the table each month.
Born To Sell, www.BornToSell.com, is a website about covered call options. To generate consistent income, take a look at the way call options work.
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