If you are looking for ways to generate some extra income from your portfolio – without getting too risky or complicated – you may be interested in a little trick known as covered call writing. In a nutshell, this means selling other investors the opportunity to buy stock from you at a locked-in price – a.k.a. a call option.
We have discussed call options before, but mostly in terms of their use as an employment perk. They are a bit of a different animal when you are selling them on the open market. An example might be the easiest explanation:
Covered call writing in action
Sally has 100 shares of Apple that she does not necessarily need or want to sell… at least not at the current price of $173 per share. But she could part with them for, say, $200 per share. She also knows there are wannabe buyers out there who expect Apple to exceed that value soon, and they want to nab shares of their own before it does.
So instead of selling her shares for the current market rate, she writes a covered call option with one of these optimistic buyers. This is a contract which states that the buyer may purchase those 100 shares from her at a locked-in price (or strike price) of $200/sh, anytime in the next 5 months. In return for this opportunity, the buyer fronts a premium of $1.50/sh for $150 total.
Now here is the big question: what happens if Apple’s share price does or does not reach the strike price?
Scenario #1
Apple’s share price never gets above $200/share during the 5-month option term, and Sally’s buyer lets the option expire without exercising. After all, he can just buy Apple on the open market for a lower price. A bit embarrassing for him, perhaps, but not the end of the world – he is only out the $150 that he paid Sally up front.
Sally fares better. In addition to the premium she has already pocketed, she gets to keep her Apple shares and, well… do whatever she wants with them! Maybe she decides to hold them indefinitely; maybe she decides to sell once the market price does reach $200; maybe she turns around and uses them for another call contract.
Scenario #2
Four months after Sally sells the option, Apple hits a share price of $230. This is great news for her buyer – it means he can buy those 100 shares from Sally at a major discount from the market price, then turn around and re-sell those shares for a profit. So if he is paying attention, he will likely choose to exercise the option.
That would be a bit of a bummer for Sally, however, as it forces her to sell those 100 shares for less than she would have received on the open market. On the other hand, assuming she first bought those shares herself for less than $200 apiece, she still profits– just not as much as she might have otherwise.
And in any case, she still has the $150 premium! Regardless of whether or not her buyer chooses to exercise the option, that money is hers to keep.
Is covered call writing a good option for you?
As you can see, both the above scenarios work out more or less in Sally’s favor. She does miss out on potential gain in the second scenario, but that is very different from losing. And the premium she earns from selling the option itself – small though it might be – is guaranteed cash-in-hand in both cases. That is the real beauty of this strategy.
Not that covered call writing is a surefire win for everyone, however. There are a few things to keep in mind if it is to be worth your while:
- You need a stock that you expect to perform well over time, but not so well that you will be heartbroken if forced to sell it.
- You should have a good-sized stash of that stock, as options are only sold in “lots” of 100.
- It takes some savvy to find a good balance of strike price, time period and premium – so be prepared to do the homework or have someone help you with it.
But if you can check all those boxes, covered calls are a great way to squeeze extra mileage from the strongest parts of your portfolio.