Using Buy Writes Covered Calls for Extra Stock Market Income

There are several ways to approach using “buy-writes” or “covered calls” to make extra money in the stock market.

First, some foundation: “Puts” and “calls” are the two types of investment vehicles known as “equity options”. They’re also referred to as “derivatives”, because they derive from either actual or potential purchases or sales of the stock, or “equities”, of publicly-traded companies. A call gives its owner the option, but not the obligation, to buy the associated stock at a predetermined price, known as the “strike” price. A put gives its owner the option, but not the obligation, to sell the associated stock at a predetermined strike price.

Second, equity options can be traded (bought and sold) like stock, but they expire, typically on the third Saturday of each month. Recently, a new options market has developed for some widely-traded stocks: Puts and calls that become available to trade on Thursday, and expire Friday of the following week. Stocks for which weekly options are traded also retain the standard monthly options format. The universe of stocks with weekly options is expanding, but slowly.

Third, options are not traded on all stocks. Options traders tend to avoid stocks with an average daily traded volume under 6 figures (100,000 shares), usually because there isn’t enough price movement in thinly-traded stocks to make options a worthwhile endeavor.

Fourth, puts and calls are traded in “contracts”, where 1 contract covers 100 shares of the underlying stock. Brokers charge a commission to trade options. Unlike stock commissions, which usually are flat fees regardless of the number of shares traded, options commissions are typically a base fee plus 75 cents per contract.  Merely having a stock brokerage account does not grant the account holder the ability to trade options.  The account holder must apply to the broker for permission to trade options as well as stocks, and the broker must approve and authorize the account for options trading.

And fifth, put and calls have both “intrinsic” value based on the relationship of the strike price to the stock price, and “time” value based on how much time is left before the options expire. A call with a strike price higher than the stock price is “out of the money”; if the strike price is lower than the stock price, the call is “in the money”. For puts, a strike price higher than stock is said to be in the money, and a strike lower than stock price is out of the money.

You don’t need a brokerage account to investigate equity options opportunities.  Simply visit the Chicago Board Options Exchange (CBOE) web site. There are dozens, if not hundreds, of other sites that provide free equity options education and information.

A “buy-write” and “covered call” are essentially the same thing: Buying or owning stock entitles the stockholder to sell, or “write”, call options on that stock. The written call is “covered” by the corresponding shares of underlying stock.

This could be a short-term tactic. An investor who believes the price of a stock will move up in the near-term, but then drop, could buy the stock, write a call, and collect a profit on both if his idea pans out.

Example 1: XYZ Corp. stock is currently $20 a share. Joe Investor thinks it will hit $25 in two weeks, when the calls will expire. Joe buys 100 shares at $20, and sells (“writes”) a $25-strike call for $1.00 (multiplied by 100 shares = $100). If the stock climbs above $25 before the call expires, the holder of the call can “call away” Joe’s 100 shares, for which Joe will get $25 per share, plus Joe keeps the $100 he got for the call.  If Joe changes his mind and decides to keep the shares, he has to buy back the call either before it is exercised by its holder, or expires, and doing that will almost certainly cost him more than he received for writing it.  An in-the-money option can be exercised by its holder anytime before it expires, with no notice to Joe.

Example 2: The stock climbs to $24 by the call expiration date. The call holder doesn’t want to pay $25 a share for a $24 stock, so he lets the call expire.  Essentially, the call holder bet $100 that the stock would be higher than $25 before the call expired, and he lost. Joe keeps the $100 he got for the call. He can then either sell his 100 shares of stock for $24 a share, or hold the stock and write another call for the next month (or week, if weekly options are available for XYZ Corp. stock).

Or, writing covered calls could be a long-term strategy.  Remember, Joe thought the price of the stock would move up, but not stay up. So if Joe holds the stock, he’s going against his original strategy, and risks losing some of his money if the stock price moves below $20 a share. But Joe can hold the stock and sell out-of-the-money calls for as long as he wants, as long as the stock price stays below the strike price of the calls.  Theoretically, this could result in Joe eventually getting the stock for free, if he sells enough out-of-the-money calls to make back his initial cost of buying the stock.

Once that point is reached, Joe can generate income by selling out-of-the-money calls as long as he wants.  Joe’s potential downside is that the share price of his stock will drop below his purchase price, but as long as other investors are willing to buy Joe’s out-of-the-money calls, he can make money selling them.

Another potential risk for Joe is that options traders could lose interest in Joe’s stock, making it not worth Joe’s time or trouble to sell out-of-the-money calls.  If a stock’s price becomes stable, or “range-bound”, options premiums tend to shrink.  Also, a covered call caps the call writer’s profit potential on the shares of stock. If Joe writes a $25-strike call, but the share price jumps to $50, Joe gets $25 per share when his shares are called away.

There are no risk-free investments. Always observe, study and practice before putting your real money in the game. Good luck!