How can income be created from the stock market?
An excellent strategy to create income from the stock market is through a covered call strategy. This involves selling a call option against a stock that you own. The money you get from selling the call option is income to you whether or not it is exercised. Let’s look at an example.
A common covered call strategy is called a Buy/Write, which simply means that the stock is bought and the call is sold simultaneously.
The covered call writer (seller) buys 100 shares of Income, Inc. for $24.75 on September 17, 2008. The writer then immediately sells one October 07 $25 call option for $1. The writer keeps the income (premium) from the sale of the call, calculated as follows, $1 x 100 =$100.
The call gives the right to the purchaser to buy 100 shares of Income, Inc. from the writer/seller, at $25 per share on the expiration date, or third Friday of October, in our example.
One option contract is equivalent to 100 shares of stock.
If the writer bought 500 shares of stock, then 5 contracts could be sold against the 500 shares. In this example, 100 shares of stock were purchased, therefore one contract was sold.
If the stock is above $25 at option expiration, the option buyer will exercise the right to buy the stock at $25. The seller keeps the difference between the purchase price of $24.75 and the $25 option strike price, x 100 shares, or $25, in addition to the $100 kept at the time the call option was sold. This equates to a total of $125, or 5.0% of invested capital. This is an ideal outcome for a Buy/Write covered call.
If the stock price is below $25 on the third Friday of October, the option will not be exercised. The writer still gets to keep the $100 option premium collected when the call was sold. The call writer continues to own the 100 shares of stock, and may then choose to sell a call for November with the same strike price if the stock price is still near $25. If the stock has dropped significantly below $25, the owner of the shares may wait until the stock nears $25 again, or use other option techniques. While the
lower stock price is undesirable, the fact that it produced $100 of income is beneficial.
Out of the money calls
The above example was an out of the money call, meaning the strike price of the call option was higher than the price of the stock. Out of the money covered call strategies work well in an up trending market since they are more likely to be called, or exercised. A portfolio of diversified covered call positions can create a nice monthly stream of income, as it is common to see option premiums equal to between 2% and 5% monthly.
Camille Gaines has been trading stocks for over twenty years. She is founder of an educational website for investors www.TheFinancialWoman.com.