How to Make Passive Income with Covered Calls

Member

By jtreptiles
User-Submitted Article

Article Rating: (2 Ratings)

Passive Income

This article is written for the investor that is familiar with trading stocks and has an interest in making a passive income while owning their stocks (and additionally making money from their dividends). Essentially what you are doing in this strategy is selling an option to purchase the stock at a given time (a month in this strategy) at a predetermined price (called a strike price in options terminology). If your stock is equal to or above the predetermined price on the expiration date (the 3rd Saturday of each month), you are obligated to sell it. If it is below the price, then you keep the premium (the money that was paid to you for the option to buy the stock) and are able to sell another option on the same stock.

Difficulty: Moderately Easy

Instructions

Things You'll Need:

Computer with an internet connection
A brokerage account enabled with Level I Options Spread trading
100 shares of the stock of your choice

Step 1

Ensure that your brokerage account allows you to conduct Level I options trading (or it may be entitled “Covered Calls”). Depending on your broker, this is a three or four day turnaround to become certified to do this. Additionally, most brokerages want you to have an open margin account in order to trade options. Your broker will ask several questions to determine if trading options spreads is suitable for you. You must meet their predetermined requirements in order for you to qualify for options trading.
Step 2

Choose a stock in your portfolio that you would feel comfortable selling if the price was within your control. Determine what that price is. Note: your option will be exercised (meaning 100 shares of your stock will be sold) if your stock meets or exceeds the predetermined price at the expiration date, so in order for this strategy to work, you must ‘be okay with’ selling your stock at the predetermined price. The object of this strategy however is to have the option expire, in which you keep the option premium and are able to sell another one at expiration. During this time you are entitled to all of the other benefits of owning your stock (to include dividends and distributions, shareholder proxy and voting).
Step 3

Determine the stocks monthly trading range. Say its July, and I own 100 shares of British Petroleum (BP). The current price per share is $47.24. I think that it is a tad overpriced, but since I bought it at $44.60, I have no real concerns. I decide that if it reached $48.00 within the next month, I would be willing to sell it...for a price.
Step 4

I research the August options chain for BP. I see that selling the option to buy (in options terminology this is known as writing a call) my 100 shares of BP at $48.00 will make me $160.00. I sell the option by clicking the options ticker (in this case +BPHC). Remember, each option controls 100 shares of stock. I choose that I could like to sell to open 1 contact of +BPHC). Much like a stock I could sell the option at a limit price (wait for the option to hit my predetermined price), or I could sell it for market value. In this instance I choose market value. Once I hit place order, my option is sold immediately, and the premium is placed directly into my account. I just made $160.00 this month off of my stock that I had bought for $44.60. That is a 3.5% return in one month for something I already own!
Step 5

Should BP meet or exceed the at the options expiration date, the stock will automatically sell at the strike price (in this case $48.00). Eight out of ten times however, the options expire without having met their strike price. When this happens, you are free to turn around and repeat the process. If you can continue to replicate these results, you’ve made an additional 42% on your money for the year...and this doesn’t include your dividends!

Comments

ceniamari said

Flag This Comment

on 7/21/2009 I don't invest freely because of the lack of knowledge. I wasn't aware of this strategy. Thanks, this article on covered calls will make me research topic.