Dividends are fantastic. Just like receiving interest each month, dividends are passive income waiting to be accrued 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 the same — covered calls.
Before we can talk about covered calls, let’s talk about calls. A “call option” is a security that gives the buyer the right to buy stock at a certain price before a certain date. In exchange for this right the buyer pays ‘premium’ (money) to the call option seller. If the buyer then decides he wants to exercise his right, the seller is obligated to sell the shares at the agreed upon price (but, keep in mind, the seller gets to keep the premium).
Imagine Tom is bullish on ABC Corp. He wants to buy 100 shares of ABC Corp for $30 between today (March) and 3 months from now, but he doesn’t have enough money to buy 100 shares. So instead, Tom buys one call option on ABC Corp stock with a strike price of 30 that expires in June. Let’s imagine ABC Corp is trading for $27 today… so Tom might pay $100 (for example) for the right to buy ABC Corp at $30 between now and June. He does this because he believes ABC Corp will go above $30 between today and June. If ABC Corp rises to $40 then Tom can exercise his option right and force the seller of the call option to sell him 100 shares of ABC Corp at the agreed upon strike price ($30/share). Tom will have to pay $3000 for these 100 shares, but he can then sell the shares for $4000, pocketing $1000 (less the $100 in premium he paid to the seller when he bought the call in March). On the other hand, if ABC Corp finishes below $30 in March then Tom’s option expires and he loses the $100 in premium he paid.
By selling covered calls to speculators you generate monthly income. But, and this critical, you only want to do it with stocks you already own. Because if the options you sold are exercised against you, then you will already own the stock needed to deliver. That’s why it is called a ‘covered call’… your obligation is ‘covered’ by stock you already own. If it so happens that your stock is called away then you receive the strike price per share for your shares.
Many people use covered calls to generate monthly income. It is a passive strategy where you can collect option premium each month. If one of your stocks rises above the strike price then the option buyer may exercise the option and pay you for your stock. You still made money, but you may not have made as much as you could have if you hadn’t sold the option. On the other hand, the option premium that you’ve been collecting each month gives you current income and some downside protection should your stock drop in value during the option’s life. Covered calls are the most well loved of all option-based strategies and are simple to learn and do.
This insight on covered calls investing is brought to you by Born to sell. Born To Sell‘s web site offers detailed information about covered call trading.
