Boost Your Income With Stock Options

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Dividends aren’t the only payments you can pocket from your stock holdings. Another way to capture cash is by selling call options against stocks you own.

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Don’t go away just because we’ve mentioned the dreaded o word. Selling so-called covered call options isn’t particularly risky or difficult once you know the essentials. The strategy can be a great way to earn a little extra cash even if your stocks remain flat or head south. “If you’re a retiree and need monthly income, selling calls can help meet your cash-flow needs,” says Nicholas Rotello, chief investment officer of Innovest Portfolio Solutions, an investment adviser in Denver.

How to use them. To do it yourself, you’ll have to know some basics about options. Calls grant the owner the right to buy a stock at a preset price, called the strike price, up to a certain date. The cost of the option is called the premium, and it generally moves up and down with the price of the underlying stock. Options can last anywhere from minutes to months before they expire. One option contract controls 100 shares of stock. A call is “in the money” if the market price of the stock is above the strike price. If the stock trades below the strike price, the option is said to be “out of the money.” The same principles apply for exchange-traded funds.If you sell calls against stocks or ETFs you own, you’ll immediately collect the premium, which you keep no matter what happens to the stock. Sell calls consistently and you’ll generate a steady income stream.

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Let’s say you own 100 shares of Microsoft (symbol MSFT, $66) and decide to sell a call against the stock. You could sell one contract expiring on October 20 with a strike price of $70 for $1.77 (prices are as of March 31). You would immediately earn $177 from the sale (less the brokerage commission). If Microsoft’s stock tops $70, even by a penny, you will likely have to relinquish your shares to the option’s buyer. But you’ll keep the premium and also benefit from $4 worth of appreciation from the time you sold the call. If the stock never exceeds $70, you’ll get to keep your 100 shares. And as long as the stock isn’t called away, you’ll also collect any dividends that Microsoft distributes. The shares currently yield 2.4%.

The main drawback of this strategy is that it caps your potential gains in a stock. If your shares get called away, you could miss out on profits in a fast-rising market. Nothing would stop you from buying the stock again at the market price and selling another call. But you may owe capital-gains taxes on the shares you sold. Option premiums are taxable as ordinary income. That could be costly if you’re in the top federal tax bracket of 43.4%. And, of course, the premium you earn from selling a call may offer little consolation if the stock tanks.

The most challenging issue may be figuring out which calls to sell. The menu of options for every stock varies widely, each with a different strike price, premium and expiration date. Some options have strike prices far above the market value of the stock, while others are below it. And many options trade infrequently, or not at all, creating a wide rift between buy and sell prices.

One simple way to use the strategy, says Rotello, is to sell actively traded calls expiring in four to six weeks with strike prices that are 5% to 10% above the market price of the stock. The individual premiums may not amount to much—maybe a nickel or dime per share for a $50 stock. But selling calls like this every few weeks could lift your annual income by two to three percentage points a year. The more volatile the stock, the greater the premium you’ll pick up with each sale (though you’ll face more risk that the stock will be called).Keep in mind, you may have to give up the stock if the market bounces higher before your call contract expires. But aside from taxes you may owe on the sale, that’s not necessarily bad. “If your stock runs up 10% in a month and gets called away, that’s a good problem to have,” says Rotello.

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Daren joined Kiplinger in July 2015 after spending more than 20 years in New York City as a business and financial writer. He spent seven years at Time magazine and joined SmartMoney in 2007, where he wrote about investing and contributed car reviews to the magazine. Daren also worked as a writer in the fund industry for Janus Capital and Fidelity Investments and has been licensed as a Series 7 securities representative.