Covered Calls: One Way to Earn Extra Income on Your Stocks Without Additional Risk

“Boy, I would definitely sell Apple if it reached $170 again,” a client said to me recently.

Like many people, she believed entering a limit order at that price was the logical next step. As we explained, however, writing a covered call option might be a better way to accomplish her objective. Compared to holding the stock until the target price, it’s a strategy that provides additional income without incurring extra risk.

Even though most people have heard of the idea, very few people seem to put it into practice. I believe this is primarily because most people just aren’t sure how or when to use this strategy. Fortunately, it’s quite straightforward. This tactic should be considered when you’ve decided to sell a certain position if, and only if, it reaches a certain price.

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How it Works

The process of selling call options against a stock you own is known as writing covered calls. In doing so, you give a third party the right (but not the obligation) to purchase the underlying stock from you at any time during the contract’s term at a predetermined price.

Here are the basic components of a call option contract:

• Strike Price: The price at which the stock can be purchased from you.
• Term: The length of time until the contract expires.
• Premium: The price the holder pays you to enter into the contract.

Consider the example of the person looking to sell Apple at $170. As of late April, Apple traded for roughly $165. (Note: The option prices cited in this example are from www.cboe.com and will have changed by the time this publishes. This is not a recommendation to buy or sell stock or options in Apple Computer Inc.)

For easy math, let's assume she holds 100 shares. If she were to sell a three-month call option on her Apple shares at a strike price of $170, as of late April she would collect a premium of roughly $7 per share, or $700 in total (less trading costs). From this point, one of two things will happen:

1. Apple trades at or above $170 prior to the option’s expiration. In that event, the option will likely be exercised, and the option holder will purchase her shares of Apple at a price of $170.
2. Apple fails to reach $170. In this case, the option expires, and she continues to own her shares. She can continue writing options and collecting additional premiums indefinitely until the stock reaches the strike price (if ever).

Either way, writing call options provides a better outcome compared to placing a limit order, since the investor will come out ahead by the amount of net premiums collected. Under the right circumstances, the difference can be substantial.

Putting it into practice

This strategy can be applied to any publicly traded stock or exchange-traded fund (ETF) large enough to have listed options. Note that this does not work for mutual funds, which is one disadvantage of an index fund compared to an ETF.

Before you can get started, you’ll need to ensure your brokerage account is authorized for options trading. You’ll need to read an educational booklet (available online) and request the applicable paperwork from your brokerage firm.

A good place to find options quotes is the Quotes & Data tab of www.cboe.com. You’ll notice that the longer the term for a given strike price, the higher the premium you can generate. Some people choose a shorter term in hopes of writing several options before the stock reaches the strike price. Others choose the longest term possible in order to maximize the up-front premium and reduce the effort involved.

Note that writing call options does not have to be an all-or-nothing proposition. For example, you can write multiple options with a series of staggered strike prices or terms, or write options on a portion of your shares. Just be aware that option contracts are typically sold in bundles of 100 shares each, which can limit your flexibility if you have a small position.

Also, as a seller of call options, please be aware that you will not be eligible to participate in gains past the call option’s strike price, and that shares may not be sold during the term of the call option’s contract. Additionally, writing call options limits the opportunity to profit from an increase in the market value of stocks.

Before taking action, you’ll want to read up on some of the particulars, including taxes, settlement procedures, etc. You can find several resources in the education section of the CBOE website that can help you get started.

The takeaway

Review a list of your positions, and ask if you would sell any of them if they reached a certain price. If so, now you have a way to potentially put some extra cash into your pocket.

Options are not suitable for all investors. Typically, commissions are charged for options transactions. Investments are subject to risk, including the loss of principal.