Everyone enjoys receiving dividends. Much like receiving interest payments, dividends are pure passive income. The best kind. You get paid no matter what you’re currently doing — reading a book, watching TV, on an airplane; it doesn’t matter, you still receive the dividend. There is another kind of investment that behaves the same way — covered calls.
To understand covered calls, we first must understand calls. A “call option” is an investment product that gives the purchaser the right to purchase stock for a known price (called the strike price) on or before a certain date (called the expiration date). In exchange for this right the buyer pays ‘premium’ (money) to the option seller. If the buyer later decides he wants to exercise the right granted to him by the option, then the seller must sell the shares at the strike price (the seller also gets to keep the premium he received at the beginning of the trade).
For example, let’s say Bob wants to buy 100 shares of XYZ for $50 between today (December) and three months from now. Bob buys one call option on XYZ stock with a strike price of 50 and an expiration date of March (for example). Let’s say XYZ is trading for $45 today and so Bob might pay $100 for the right to buy XYZ at $50 between now and March. He would do this because he thinks XYZ will rise above $50 between now and March. If XYZ shoots up to $60 then Bob can exercise his right and force the seller of the option to give him 100 shares of XYZ at the strike price ($50/share). Bob has to pay $5000 for these 100 shares. He can then turn around and sell the shares in the open market for $6000, pocketing $1000 (less the $100 in premium he paid to the seller when he bought the call option in December). However, if XYZ finishes below $50 in March then Bob’s option expires and he loses the $100 in premium he paid.
By selling covered calls to other investors you create recurring income. But, and this critical, you only want to do it with stocks you already own. Because if the options you sold are exercised against you, then you will already have the stock needed to deliver. That’s why it is called a ‘covered call’… your obligation is ‘covered’ by stock you already own. If it so happens that your stock is called away then you receive the strike price per share for your stock.
Many people use covered calls to create recurring income. It is a passive investment strategy where you can collect a little option premium each month. If one of your stocks goes above the strike price then the option buyer may exercise his option and pay you for your stock. You still made money, but you may not have made as much as you could have if you hadn’t sold the option. On the other hand, the option premium that you’ve been collecting each month provides current income and some downside protection should your stock drop in value during the option’s life. Covered calls are the most popular of all option-based strategies and are easy to learn and execute.
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