How to Generate Income with Covered Calls

Microsoft

When you sell a call option, you are giving the buyer the chance to buy shares of a particular stock at a set price at some future date.

For instance, let’s say Microsoft (MSFT) is trading for $85.52 or January 3rd.  The call option to buy MSFT for $86 on January 5th sells for $0.28.  The buyer has the right to buy shares at $86.  If the shares stay at or below $86, then the option is worthless.  The seller simply profits the $0.28.  If the price goes above $86, however, then the buyer will exercise the option and the seller will have to compensate the buyer the difference between the market price and $86.  If it goes to $89 by then, then the seller would have to pay a whopping $3 per share minus the mere $0.28 they made for selling the option.  This works out to a net loss of -$2.72.  (Keep in mind that options are sold in lots of 100, so multiply all profits, losses, and option costs by 100)

Obviously the profit is capped at $0.28 but the losses are basically unlimited — a very risky move by itself.  There is a way to make selling calls much less risky; you only sell calls on stocks that you actually own.  Let’s say you owned MSFT shares.  The $2.72 you lost would be offset by the $3 gain in MSFT.  So you would still end up with a $0.28 profit.  Unfortunately, you would have lost out on the $3 gain you would have made by simply holding onto the shares and selling no options.  So you gained some income but traded a lot more upside.

Covered calls are useful in some situations.  One is that you think that a stock will lose value but don’t necessarily want to sell it (perhaps to avoid paying capital gains taxes).  Another would be if you thought a stock was going to be flat or have a minimal gain in the short term.  Still another would be if you just wanted income (yield) and didn’t really care about the direction of the stock market or a particular stock.

Someone can buy individual shares and sell options with an online broker like Fidelity, Schwab, etc.  However, others prefer the easier route of just buying an ETF that employs the covered call strategy.  Some of the most popular ones include: Horizons S&P 500 Covered Call ETF (HSPX), Recon Capital NASDAQ 100 Covered Call ETF (QYLD), and PowerShares S&P 500 BuyWrite Portfolio ETF (PBP).

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