Writing Covered Calls: is it really that easy to make a monthly income?

Aside from buying and selling shares, you can also write (i.e. sell) options. You gain additional income from premiums paid by the purchasers of option contracts. If you take this strategy, it is best to be aware that the upside potential is limited since the most money you can gain is the amount of the premium paid for the option.

You can write options either as covered or naked options. Covered options are written against an underlying stock that you already own. Naked options are written against an underlying stock that you do not own. Writing covered options is the more conservative method.

Writing covered calls (also known as ‘renting your shares out’)
You can increase income on shares that you already own by writing covered calls. This strategy is the same as a call option, except that you already own the underlying shares. Your take on the stock should be between neutral to mildly bullish.

To illustrate by way of example:

Let us assume you own 1,000 shares of XYZ stock originally purchased at $25 per share. Currently the going price for XYZ is $48 a share. You don’t want to sell the stock just yet, so you write call options (i.e. sell options to buy) on XYZ.

Since you have 1,000 shares, you can write 10 call contracts (100 shares per contract) with a strike (or execution) price of $50 per share and at a premium (the price of the option) of $2 per share, to expire in 120 days. You will thus receive $2 x 1,000 shares = $2,000 minus commissions for the contracts.

If XYZ’s stock price never reaches the $50 per share strike price before the expiration date, the buyer of the call option will not exercise the option. You, the covered call writer, will have $2,000 (minus commissions) in your account.

If the stock price does rise above the strike price, the buyer exercises the call option to buy the shares at $50 per share. Your total profit is thus $27 per share ($25 difference from selling price minus acquisition cost of the share plus $2 option premium). If XYZ share price rises much higher than $50, you will not enjoy the additional appreciation because your contract requires the surrender of the shares at the stated strike price.

Whilst writing covered calls can help your cash flow and possible income, it is best to write covered calls on shares which you think will not fluctuate very much upwards or downwards in price. If you consistently write covered call options against your stock, there will be less variability in the results of your portfolio from quarter to quarter.

The downside is that if there is a significant price decline during the option period, the buyer of the option will not exercise the call. If you decide eventually to sell the shares at the low price, you might lose money.

Put options
How do you protect shares you want to continue holding but you fear prices may go down? Buying a put option is a good way to protect the existing profits on your shares and/or limit the potential capital losses in your share positions.  You can make some money from buying put options when the price of the underlying shares drop lower than the strike price.

To illustrate, you feel a bit bearish on CDE stock that’s currently trading at $37 per share. You could buy a five-month put option at $35 per share strike price, let’s say, at a $2 premium or $200 on a contract for 100 shares. If the share price does drop lower than the $35 strike price, you can exercise the put option and sell the shares at the strike price. If the share price remains above the strike price at the expiration, you lose only the amount of premium paid to buy the option. This is the greatest amount you can lose.

The strategies described above are some ways you can increase income from your existing positions and protect your profits.