Income from options 1

Jun 11, 2010

One of the best uses for options is to earn an income from your existing shares. To do this you employ a covered call strategy. Remember that when you buy a call option you are making a contract to buy 100 shares at a set price (called the strike price) on or before a specific date in the future. Now let’s consider the other side of this trade.

A covered call: This is one of the most basic options trades and a great way to get started with options. As the name suggests, you sell a call option against an existing share position in order to “cover” yourself. Because there are 100 shares in an options contract, you must own at least 100 shares of a company before you can execute a covered call trade.

You are agreeing to sell 100 shares (for each options contract) at a set price on or before a specific date in the future. You would typically set a price higher than the existing price. This is called ‘out-of-the-money’. If the purchaser of the options contract chooses to exercise the contract (your shares are called away) you are obligated to sell at the contracted price.

When you sell the options contract you receive a premium from the purchaser, which essentially reduces the price you paid for the shares. This money immediately goes into your account to be used however you see fit. You will only be called away (when the purchaser exercises the contract) if the share price increases above your agreed upon strike price.

If this happens then you will have realized a profit on the shares and you will have received the premium as well. Additionally, you will have received any dividends that the company issued (they go to the shareholder not the option holder).

In this way you can earn an income from your existing stockholdings in addition to your regular dividends and you can choose an acceptable level of profit if you do sell. While you are giving up a theoretical unlimited profit (since the share price could theoretically rise to the moon) you are reducing your risk and earning an income at the same time.

There is also a very real possibility that if the share price does not rise above your strike price before the agreed upon date (expiration date) then the options contract will expire worthless. This means that while you earned the premium you did not have to sell your shares. You can then initiate another covered call sell to earn even more income.

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