Getting On The Right Side of Covered Calls on Your Stocks

Stock covered calls are a technique use by stock market investors to generate additional income from stocks that they already own in their investment portfolios. While options trading may sound scary, this technique for generating income is actually so conservative that most brokers will even let you utilize this technique in your online Individual Retirement Account (IRA).

A call option gives the buyer the right to buy a pre-determined quantity of an asset, usually a stock or commodity, at a specified price (strike price), on or before the expiration date of the option contract. A covered call option is a standard call option that the seller is covering with securities that are already owned in his trading account. Stock covered calls are merely standardized call options that are secured by the shares of stock that are already owned in the sellers trading account. Since each option contract represents 100 shares of stock, these covered option calls can only be sold (also known as writing a call option) based on full 100 share increments of the underlying stock that the option is being written against. For example, if an investor holds 670 shares of Cisco Systems (CSCO) in their account, they would be able to write (or sell) 6 stock covered calls.

Now that we’ve gone over what stock covered calls are, lets look at how to use them. Lets continue with the example of the investor with 670 shares of CSCO in their stock market investing account. Since CSCO does not pay a dividend, and the investor wants income without having to sell his stock, he decides to sell call options that will expire in two months, for a price that is above todays stock price for CSCO. In return for this option, the investor gets $1 per share, or $100 per covered option calls contract, times 6 contracts equals $600. This cash is deposited directly into the investors trading account, and can be used for whatever purpose the investor chooses. The investor is now obligated to sell the contract holder 600 shares of stock at the price specified in the contract, on or before the expiration date of the contract.

Now if the stock price does not go above the contract strike price, the investor who sold the option contracts keeps his stock, and the cash he got from selling the stock covered calls, and can do it all over again on the trading day after the contract expires. This is a very powerful concept, since it means that the investor can generate income multiple times per year by selling these call options.

If the stock closes above the price specified in the contract, usually around the date the contract expires, the contract will be exercised by the option holder, and the investor will have to sell him the 600 shares of CSCO at the price specified in the option contract. Since the contract price is above the price that the stock was trading at when the options were sold, the investor gets that capital gain profit, plus the cash that he was paid for selling the options.

While stock covered calls may seem a little complicated at first, in the end they provide you with a relatively easy way to generate cash flow on stocks that would otherwise just be sitting in your investment account.

Covered option calls are a popular way to generate recurring investment income in an investment portfolio, even in retirement portfolios like Individual Retirement Accounts (IRA‘s). This income can be generated on any stock in your portfolio that has actively traded options associated with it, the caveat being that you need to own at least 100 shares of the stock you are going to sell covered option calls against in order to take advantage of this money making strategy.

Let’s start by looking at what a call option is. A call option contract gives the buyer the right, but not the obligation, to buy 100 shares of stock at the price defined in the contract (strike price), on or before the date the contract expires (expiration date). One of the key concepts here is that the buyer of the covered option call contract would lose money if they exercised their right to buy the stock, if the stock is trading below the strike price of the contract. This is simply because they could buy the stock for a lower price on the open market, so there would be no point in exercising the call option contract under these circumstances.

In order to implement this income producing strategy, an investor will have to do a couple of simple tasks. First, the investor would have to ask their broker to set up their trading account to allow options trading. This usually involves reading a short pamphlet on the risks associated with standardized options trading, and signing a form indicating that you understand the risks. The investor will probably also have to tell the broker what options trades they want to be approved for, and their risk tolerance for these types of trades. As I indicated earlier, this strategy is so conservative, most stock brokers will even let you do it in your IRA account.

Next, the investor must identify which stocks they would like to sell options against. These stocks can have options sold against them in 100 share multiples, since each contract represents 100 shares. For example, if you own 230 shares of Apple (AAPL) in your account, you could write 2 covered option calls contracts against 200 shares of the Apple computer stock in your account. Finally, the investor needs to determine what price they would be like to write the contract for, and how long they would like the contract to be in place.

Once the investor has completed these steps, they merely need to call their broker (or login to their online trading account), and place the order to sell the covered option calls from their account. Once the sale is complete, the investor will receive cash in their account for the call options that they sold – this cash is theirs to keep.

If, at the end of the contract period, the price of the stock is below the call option strike price, then the investor keeps their stock, and can write new covered option calls against their shares of stock. However, if the stock price has risen above the strike price of the option contract, then the investor will have to sell his shares to the contract holder at the strike price specified in the agreement.