Posted on May 2nd, 2011 
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You can actually make money on the stocks you already own through a strategy called covered calls. Many investors have never heard of covered calls and of those that have heard of covered calls, many don’t understand the strategy or have the tools to execute the covered call strategy successfully. Ignorance is costing you money though, and it is pretty much passive income you are missing.
Covered calls are generally thought of as a boring, conservative investment strategy.
How do Covered Calls Work?
Mr Investor owns 1000 shares of stock in ABC Company. He likes getting dividends and capital appreciation but he is missing out on another pretty passive income stream from his ABC stock. This income can come from writing covered calls.
Let’s assume that ABC shares are trading at $10 each right now. Mr Investor can sell the right (called an option or a call) to Mr Speculator to buy his 1000 shares of ABC Company at some point in the future for a particular price (called a strike price). For providing this option or call Mr Investor collects an option fee.
Mr Speculator is paying the option fee as a bet that ABC Shares will be worth more than the strike price before the strike date. If Mr Speculator is right in his bet he can exercise his option to buy the shares and than resell them into the market at the higher price. If he bet wrong he is only out the cost of the option and did not have to put out the cost of buying the stock and holding it.
Mr Investor might end up keeping both his stock and the option price or he might end up getting to keep the option payment and selling his stock for the strike price agreed too.
There are variations on the system. For example, instead of selling his stock when the call is exercised Mr Investor could buy an offsetting option and close out the two positions.
Is Option Trading Risky?
Absolutely, if you want it to be risky. Trading options “naked” can get pretty scary. If you sell an option that you don’t have the ability to settle with shares you already own you may be forced to buy those shares at some high price and immediately sell them at a loss.
Writing covered calls is absolutely risk free. The worst that can happen is that the call buyer requires you to sell the stock you already own at a price you agreed to. The only risk is opportunity risk – the sale price might not be as high as what you could get in the open market. That is the same risk as selling right now because you are forgoing the chance to profit from the stock going up in the future by selling now. Regardless of what happens you get to keep the proceeds of the option.
If you approach the transaction assuming that you will be selling at the strike price, and that is a price you are happy to accept, than who cares what the market does in the future? Hopefully you get to keep both the option price and the stock, but if you have to sell you get the sale price for the stock too.
Covered Calls can also be used on highly rated bonds and on ETFs as well as individual stocks.
Source: Jade Dragon
