Selling Covered Calls for Extra Passive Income?

Earlier this month I wrote about selling options as a goal to get making a little more passive income.  It’s more work than simply investing in a broad market ETF where statistics show you’ll average around 8 to 10 percent a year over the long run, but it’s also something that interest me a lot and I’d like to see if you could make an ongoing monthly income doing it.  One of the ways I’d like to start making extra income is by selling covered calls.  It is considered by some to be less risky than simple buying calls or puts, which can end up with a zero value at the end of the period.

One of the reasons I’d like to review covered calls is you may already have everything you need to get started in your investment account already. Writing, or selling, covered calls can be an excellent way to add a little extra income to your portfolio in a sideways moving market.

Selling Covered Calls – What you need

Before you get started with selling covered calls you need to understand a few basic things. First, you have to own at least 100 shares of a company’s stock for this to even be possible. Second, the stock you own has to be optionable. This means that people can buy and sell options on the stock. Third, your account has to be approved for options trading and finally, you have to be willing and ready to sell your stock at a certain price. Don’t worry, you get to decide the price.

Selling Covered Calls – How it works.

Here is a basic way to understand how you make money selling the calls. It is kind of like a lease option on a home. When you give someone a lease option on your home, you collect a lease payment for an agreed amount of time and at the end of the lease, the other party has the option to buy your home. Usually you agree on the purchase price of the home at the start of the lease.

Similar to a lease option, when selling covered calls you are essentially leasing your stock to another person for a certain amount of time. It’s usually shorter than that of the lease option on a home and can be as short as a month or the time left until the next expiration date. When sell a call you will receive a premium similar to the lease payment in the house example. At the end of the option period, the option expires. If the stock is higher than the strike price you agreed to sell it for, the stock will be sold from your account. If not, the option expires worthless and you can sell another call option and reset the price and date.

Here is how it works. Choose the stock you wish to sell the option on. Look at the available options on the stock. In this case you will be looking at the call options. Generally there will be call options for the next few months and then quarterly or annually as the time period gets farther and farther from the current date. If you want to look at options and never have, you can see some prices on Yahoo.com’s finance section. Just type in they symbol and then click on the options link.

Look closely at 2 things. First review the strike prices. The strike price in a covered call is the price you are willing to sell the stock for. Keep in mind what the stock originally cost you. For example, if you bought the stock for $20 per share and the price is still around $20 you probably would not want to sell the $18 call option if you intend to keep the stock. At the end of option period, if the stock price is higher than the strike price you agreed to you will get called, which means you will sell the stock at the strike price you agreed to ($18, which would be loss of $2 or 10%). The second item to look at is the expiration date. The expiration date of your covered call is the date which the option you sold either gets called or expires worthless. If the stock is above the strike price on your covered call at the expiration date, the call option will be exercised, meaning the stock will be sold from your account at the strike price. If the stock price is lower than the strike price the call option expires worthless. Generally people selling calls hope the call options expire worthless so they can write another call each month or quarter.

Selling covered calls varies slightly at each broker. However the concept is the same. Find the strike price and expiration date you are comfortable with and choose the option to sell the call. Keep in mind that when you do this you can not sell your stock while the option is open. You can however buy back the option at any point if you choose to sell the stock. The price of the option will reflect any changes in the stock price and the time remaining until expiration and could cost more than what you originally received when you sold it and collected your premium.

Selling covered calls can earn passive income

Depending on a few different things, like how close you set the strike price to the current stock price, the volatility of the stock and the timing of the sale of the covered calls you could start to make an additional passive income that will give a little boost to your portfolio.

There are a lot of variables to consider that will affect the amount of income you can generate.  First is the stock.  Not all stocks are the same when it comes to investing.  The premiums are often higher when the expectation of movement in the stock price is greater.  You have to watch out here, because sometimes you might want to sell options on a stock to get the higher premium, but put the strike price to close and end up missing out on some great gains because of the movement in the price of the stock.

Another consideration is the expiration date.  The farther out you go the higher the premium will be, but again you have to consider you might end up selling the stock before or at a price under the current market.  Make sure you are ready to sell.

If you like the idea of selling covered calls for income you might also like selling cash secured puts.

Tips to remember when selling covered calls:

1. You can always buy back the option. (It could be higher or lower than what you sold it for.)

2. Calculate the gain or loss on the sale of you stock (in case you get called out) before you sell the option.

3. Don’t forget to include the transaction costs when calculating your returns (It can make a big difference in your decision)

4. If the stock goes down you can still keep it. (unlimited downside, but you already owned it anyway, right?)

5. If the stock goes up, your upside is only as high as the price you set. (limited upside potential, but you sold the option to collect some income, not make huge capital gains)

Bottom line?  The goal hear is to learn how to make your money work for you and get out of you working for your money.