Sell Call Options to Boost Your Stock Income
By Steve Gillman
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
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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
http://finance.yahoo.com
- 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.
http://www.tradeking.com
- 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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