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How to use covered calls to generate recurring income.
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Covered Call Strategy
The covered call strategy has been used by income-oriented investors for decades. By sacrificing some upside potential the investor receives some downside protection. If the stock has stayed flat or gone up by the time the option expires then income has been generated. It's even possible to make money if the stock goes down a little, which is why this is a popular strategy for conservative investors.
The covered call strategy is the easiest option strategy to grasp, the most popular, and the most conservative. It is also the one that most investors begin with when starting to invest with options.
Quick review (if you need a longer explaination, see the covered call tutorial): (1) you need 100 shares of stock or ETF, (2) you then sell 1 call option (because options control 100 shares) against the stock/ETF you own, and then (3) at expiration you may end up having your stock called away (and receive cash) or you may end up owning your stock and having the call option expire worthless (in which case you can sell another call for the next cycle).
The option you, as the covered call seller, will sell is a "call option". It has an expiration date and a strike price. You can choose both. For example, if you owned 100 shares of XYZ that was currently trading at $45/share, and if you would be happy selling that stock at $50/share next month then you would sell 1 call option with a strike of 50 that expires next month.
On expiration day if XYZ is less than 50 then you keep the stock and the money you got from selling the call. If XYZ is over 50 then you will lose your stock but you will receive $50/share of cash in its place (plus the money you got from selling the call in the beginning).
You can make money with the covered calls strategy even if the stock drops.
This is the part that gets most people excited. Let's look at a real-world covered call example. Right now, you can buy ATPG for $16.20. You need 100 shares, so that's $1620. After that you can sell 1 Dec 15 call option for $1.88 (strike of 15, expiration date of Dec 18, 2010). You will receive $188 today.
At this point your break-even is 14.32 (16.20 - 1.88). If ATPG closes above your break-even point on Dec 17 (last day the Dec options trade before they expire on the 18th) then you've made money. That means the stock could drop $1.87 (11.5%) between now and Dec 17 and you would still make a profit. That's what we mean by "stock could drop and you could still make a profit" -- that's why people like this strategy. If the stock drops 10% in 40 days you've still made a profit... because you sold an in the money call option.
If ATPG is above the strike price (15) on Dec 17 then you will receive $1500 for your 100 shares. Remember, at the start you paid 1620 but you received 188 so your net debit was $1432. So you made (1500 - 1432), or $68, on an investment of $1432. That's 4.7% in 40 days, or 42.9% annualized. Nice!
The covered calls strategy is not get-rick-quick. But it can produce profits at regular intervals. You'll want to have multiple positions in different sectors for diversification. If you have a small account then consider ETFs since they have some built in diversification.
Mike Scanlin is the founder of Born To Sell and has been writing covered calls for a long time.