Selling Covered Call Options: How To Instantly Turn Your Stocks Into Passive Income
by Lee Lowell, Advisory Panelist, Investment U
Monday, November 13, 2006: Issue #607
If you’re an investor who’s long on a stock right now, I want to show you how to make money by selling call options while you’re waiting for the stock to move higher.
At this very moment, there’s another investor somewhere who’s willing to pay you cash – today – in return for the opportunity to possibly take your stock from you at a higher price sometime in the future.
That means you can start making passive income right now all due to your having some shares sitting in your account.
Here’s how it works…
Selling the “Rights” to Your Shares With Covered Calls
If you own at least 100 shares of stock in your account, you have the opportunity to sell a covered call option against those shares.
What does that mean?
Basically, you can sell one call option (one option contract equals 100 shares) against the shares of the company you already own.
In doing so, you’re giving up the right to own the shares to the person who buys the option from you. So he now has the right to buy the shares from you at a pre-determined price (this is called the strike price) and at a pre-determined date (known as the expiration date).
For that right, he must pay you money – yours to keep, free and clear, no matter what happens in the future. That’s your return.
If the stock moves up past the strike price of the option you sold, you will then be obligated to sell your shares of stock to the option buyer at the stated strike price. Is that a bad thing? Not if you do the trade correctly, and have a price in mind that you would be willing to sell the shares anyway.
Let me give you a real-life example of how this covered call trade works…
Turning IBM Into An Income Machine
My parents both own 800 shares of IBM that they’ve held for many, many years. Over that time, they’ve obviously experienced the ups and downs, but have still not cashed out of the stock.
But now they’ve finally decided that if they’re going to sell their IBM shares, it’s going to be when the stock is $95 or more. Fair enough. But instead of simply having them enter a sell order limit at $95, I got them to sell some covered calls against their 800 long shares at the $95 strike price instead.
Since each option contract is the equivalent of 100 shares of stock, my parents sold 8 call option contracts each.
Take a look at the IBM chart below:
We sold the first set of call options on March 17, 2006 – selling the January 2007 $95 strike calls for $1.95 each. That brought in an immediate $3,120 (16 x $1.95 x $100 multiplier = $3,120) into my parents’ accounts.
We chose the $95 strike calls because if IBM ever happened to trade above $95 by option expiration in January 2007, my parents would get the stock called away from them at that price. So instead of sitting around, waiting and hoping for IBM to eventually move back up to $95, they got proactive with their portfolio, sold some calls and made easy cash.
Obligation-Free Covered Call Options
Since you’re never obligated to hold onto a call option, we decided to buy back the calls in the middle of July 2006 in order to take a profit on the option side of the trade. Even though IBM was moving down in price (and causing a paper loss on my parents’ long stock), the call options were getting cheaper too, giving us a gain on those.
We bought all the calls back for $0.15 each, which cost us $240 total (16 x $0.15 x $100 multiplier = $240). So in essence, we locked in a real-life gain of $2,880 ($3120 – $240 = $2,880). Sweet!
Since we bought the options back, we were left with no more obligation to sell IBM at $95/share. My parents had their 1,600 shares of IBM just sitting in their account again. And we waited for the next chance to sell a covered call
Using Covered Call Options to Deposit Another $4,800 Into the Account
The next opportunity occurred about three months later, after IBM gapped up to $92 per share on October 18, 2006. Because IBM had rallied back $18 a share, it was a good time for selling more call options.
My parents opted to sell the April 2007 $95 calls this time, and they collected $3 per option, which brought in another $4,800 of fast, easy money. All they have to do now is sit and wait to see if IBM gets to, and then stays above, $95 per share by the April 2007 option expiration.
If that happens, they will sell their shares for $95. If IBM stays below $95 at April expiration, the calls will expire – and my parents will keep their IBM shares and will look to do another trade sometime in the future.
The covered call strategy is a sound and easy way to bring in extra cash every few months. If you have stock sitting idle in your account, and have a pre-determined sell point, don’t just wait for the stock to reach that level, sell call options against your stock at a strike price that coincides with your sell point. Make your stocks work for you, instead of you working for your stocks.
Good trading,
Lee Lowell
Today’s Crib Sheet
- Selling call options is a great way to generate income in your brokerage account. Buying them can also be extremely profitable, especially if you have time on your side.
Any investment contains risk. Please see our disclaimer.
6 Responses to “Selling Covered Call Options: How To Instantly Turn Your Stocks Into Passive Income”
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“That brought in an immediate $3,120 (16 x $1.95 x $100 multiplier = $3,120) into my parents’ accounts.”
Where did the 16 come from? I thought you said your parents owned 800 shares (so wouldn’t that be 8 contracts? or 8×1.95×100?) Or did you mean your mom owned 800 shares AND your dad owned 800 shares for a TOTAL of 1600 shares? Would help to be more clearer on the total shares of IBM your mom and/or dad owned.
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John Doe,
BOTH parents had 800 shares of IBM for a total of 1600 shares.
Anyway, This is a great trading strategy for the patient among us. It really helps those who buy undervalued stocks that we’ve come up with a fair value for and have the time to wait for that price. If it goes above that price, GREAT!, take it please! If it doesn’t, I’m making money in the meantime.
Great article.
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Ok, how is the passive income from the sold calls reported on your 1040. Is it a short term gain, ordinary income or what?
Bill
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Nice article. I’ve been selling covered calls for years. It’s possible to get 1.5%/month (18%/year) without taking much risk. Just stay away from earnings release dates before expiration, and seek out dividend stocks that have an ex-div date before expiration (so you get the dividend, too). A good screener does it for you: http://www.borntosell.com
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I’m glad you used the example with IBM and not some volatile stock with a huge premium. This strategy works great for conservative investors with a long-term mindset.
For the tax question: the premiums received are treated as short term capital gains. You can read more about that at sell call options
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if you get called out, do you keep the credit from the call option sold? what happens if the call option is worth more than what you received when you sold it?
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