Sell Call Options to Boost Your Stock Income


Perhaps you haven't considered that you can sell call options on your stocks to generate extra income. Maybe you are not even quite sure what call options are, so we start there. But to keep you reading I should mention that you might be able to make an extra 5% to 10% per year on your stocks without ever selling them, using the strategy laid out below.

An option is the right--but not the obligation--to do something. A "call option" gives the holder the right to buy a certain stock at a set price by a set date. A put option gives the holder the right to sell a sock. Options cover 100 shares each. The "strike price" is the price at which the holder can exercise the option (buy the stock in the case of a call or sell in the case of the put). They are specified by month, and expire on the third Friday of that month. So, for example, of the many options available on Coca Cola (symbol KO) at the moment (this is being written after markets closed on 12/2/10), one is a Jan 67.50 call. That means that the holder of each option has the right to buy 100 shares of Coca Cola stock for $67.50 by January 21, at which time the options expire. The stock closed at $64.50 today.

At the moment, the buyer of such an option has to pay 36 cents times 100 shares, or $36 for the option, plus commission, and is gambling that Coca Cola stock will be worth more than $67.50 before expiration. For example, if the stock goes to $70, the option would be worth close to $250, since the holder could buy 100 shares for $6,750 ($67.50 x 100 shares) and sell them for $7,000 ($70 x 100 shares). This is called an "out of the money option" by the way, because the strike price is higher than the current price. There are plenty of "in the money" options as well. For example, today you could buy a Coca Cola Jan 55 call for $10.05, or $1,005 for the option. The out-of-the-money ones are what we are interested in, since we'll be selling them and most of them expire worthless.

Now, here's something most people don't know. Warren Buffet, despite being a great judge of value, did not make all of his fortune just from picking good stocks. He has been known to sell call options to generate extra income from his stocks. He can sell options worth millions of dollars every month on the stock he has, and if the strike price is far enough out of the money, the chances that someone will exercise those options is very small. Millions per month and he still owns the stocks.

How Much Can You Make?

Let's look at some very specific examples using today's actual prices to show how you can do this if you invest in stocks. Lets say you buy 400 shares of Tesoro Corporation (TSO) today at 17.39. With your $6 discount commission you have $6,962 invested. Now, you plan to hold this for a long time, but you want to earn some extra income from it, so you check into the call options you can sell. The Dec 18 call is going for 27 cents. It expires on December 17 (third Friday), in 14 days. Thanks to easy online investing accounts, a minute later you have sold 4 of these. Remember that 27 cents is the per-share price, but an option covers 100 shares. You are paid $108, netting $102 after a $6 commission. If the price of your stock tops $18 and stays there for long, your shares will likely be purchased by the option holder.

Now, let's assume that the stock doesn't go above $18 in the next 15 days. You made $102 on an investment of $6,962, or 1.47% in two weeks. If you can do this once every month you will make an extra 17.6% annually. Notice that this means even if your stock dropped in value by 7% you would be 10% ahead. But what if the price did jump above the $18 strike price? The option holder would pay you $18 per share, so after the commission (assignment fee really) of $20, you would get $7,180, and you still have the $102 you made selling the option. So you have $7,282, which means you made $320 on your investment of $6,962, for a return of 4.6% in less than a month. The only way you can really lose with this strategy is if the stock price just keeps falling, and even then you lose less than others, since when you sell call options you generate income that offsets the loss.

By the way, if you are really in love with the stock and afraid of it being bought out from under you, you can go further out on the strike price. At the moment, the Jan 20 call is at 23 cents, so after commission you would collect $87. The expiration date would be January 21--almost six weeks out--but it's unlikely that the stock will go up the 15% necessary for the option to be exercised. If you sold six options at abut this price every year, you still would make an extra $522, or 7.5% on your investment. And should the stock still exceed the strike price? Well, you could buy the stock back if you really want it, or you could be content with your $1,105 profit, a 16% return you made in just six weeks, and look for other opportunities.

One more example: Computer maker Dell Inc. (DELL) closed at 13.69 today. Lets say you bought 500 shares at that price, for a total after commission of $6,840. You could have sold five of the Jan 15 call options at 0.13 per share, for a total after commission of $60. If you were "called out" (the price rose above $15 and the options were exercised), you would make $695 after all commissions, a return of 10% in six weeks. If the price stayed below $15, you made $60 and the stock is still yours. Do that six times per year and the $360 represents and extra return of 5.2% on your investment.

Big Important Note: You probably realized by now that there is one big problem with this strategy. It is that you will always miss out on the huge moves if someone has the right to buy your stocks at a set price. What if Dell went to $40 in January? You sold at $20. In exchange for more consistent returns, and the downside protection that you get when you sell call options, you give up profits from the big moves (although you could just sell options on half of your holdings to benefit from both possible scenarios).

Ways to Make More | Related Opportunities | Tips

This is primarily a strategy for generating income from stocks you already own, but you can use it as a way to lower your costs when entering into a stock. For example, Marathon Oil (MRO) closed at 35.11 today, and the Jan 36 call can be sold for 80 cents per share. If you bought 400 shares of MRO for about $14,040 after commission, and sold calls on all of it, you would immediately get back $315. You essentially bought the stock for 2.25% less than the current price. I have seen instances where you could immediately recover 10% of the purchase price with out-of-the-money options. And remember that because out-of-the-money means the strike price is higher than the current price, you make a profit if the options are exercised and you lose your stock.

There is a "bid" and an "ask" for options, just like stocks. The bid is what the market maker is willing to pay you for an option. The ask is what they'll sell the same option for. Spreads can be much greater than on stocks though. For example, it is common to see a bid of 30 cents and an ask of 40 cents on the same option.

Qualifications / Requirements

You have to meet certain requirements before most brokerages will allow you to trade options, but they are minimal if you are only selling what are called "covered options," which means you only sell options on stocks you own (speculators sell "naked options" and have to buy the stock to fulfill their promise if the option is exercised--potentially very dangerous). Mostly you have to acknowledge the risks in writing and have some previous experience buying and selling stocks.

A warning: If you want to sell your stock while you have options outstanding, you'll have to buy back your options or wait until they expire. You could watch as the price of your stocks fall while you wait for expiration. You are not entirely trapped in your stocks, but who wants to spend money to buy back options when you're already losing on the stock?

First Steps

Open a discount broker account to keep the costs down. Selling a 10 cent option on 400 shares only gets you $40, which would be half eaten up by a $20 commission. There are plenty of places that will only charge you $5 or so. Test the waters slowly, suing stocks you plan to hold long-term, and selling only out-of-the-money options that expire in the next two months.

Resources - Enter a stock symbol and you'll get all sorts of information. Click on the options button to see if you can sell call options on that stock, and for how much. - One of many discount brokers that can be used for this strategy. At the moment they charge $4.95 per trade plus 65 cents per options contract, so, for example, it would cost $7.55 to sell options on 400 shares (4 contracts).

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