Covered Calls – Earn Income from your shares

If you own a portfolio of stocks you may be missing out on monthly income opportunities without even knowing it. Very few investors are familiar with the idea of selling call options over their shares. This is a strategy that would allow them to earn income from your shares every month regardless of whether they go up, down or sideways.

When you sell a call option you sell an investor the right to buy your shares at an agreed price for a limited period of time. The agreed price is called your strike price. The end of the period you can exercise the option in your expiry.

Let’s look at a basic example for how a call option works: and

  • Company A is trading for $10 a share
  • Investor A own 100 shares of Company A and wants to sell a call option with a strike price of $11 a share. They sell the option for $0.30 (3% of the existing price) and bank that as income.
  • Investor B believes that company A will increase in price through the month and they buy the $11 call option for a total outlay of $0.30.

So far we have Investor A, who has made a 3% return on their shares for the month. A very strong return for just four week period.

Investor B has paid $0.30 for the right to buy these shares. This gives them the exposure to the capital growth of the shares, but their risk is capped at $0.30. If they just bought the shares for $10 on the market then they will be exposed to a much higher upfront cost and greater risk. When buying the option their loss is capped at $0.30 per share instead of the market [price of $10.

Let’s look at the possible outcomes.

Option Expires with a share price of $9.50

The price of the stock is below the strike price ($11) and the option expires worthless. Investor B loses his $0.30 investment.

Investor A has banked the $0.30 premium after selling the option, so their loss is only $0.20 ($10 share price – $0.30 income = $9.70 break even). Investor A can now sell another option for a future expiry date. If they were to achieve another $0.30 premium then their break even is lowered to $9.40. So they have made a profit despite the price of the shares dropping from $10 to $9.50.

Option Expires with a share price of $10.50

The price has increased, but did not reach the strike price of $11. The option expires worthless and Investor B loses his $0.30 investment. Investor A banks the 3% return of the month and can then sell another call option for the following month and bank another premium.

Option Expires with a share price of $11.50

In this scenario the share price has exceeded the strike price and the option has been exercised. Investor B pays $11 for the shares that are now worth $11.50. Their all in cost is now $11 plus the premium they paid for the call option of $0.30. So they have a profit of $0.20 for each share they have bought with the option.

Investor A has had to sell the shares to Investor B. When reviewing their return we have to account for the premium they received of $0.30, plus at the sale price of $11 they make an additional $1 in capital growth on the shares. A profit of $1.30.

You may notice that if Investor A did nothing and held the shares in this scenario that he would have made a profit of $1.50. So if you are chasing purely capital growth this strategy may not be for you. However, if you want income upfront and would like to minimise the risk of losing money if the share price declines then this can add some additional protection into your portfolio.

You can take this further and protect your downside by purchasing a put option. This is the opposite of a call option. The buyer of a put has the right to sell shares at an agreed strike price.

When you sell a call option, and buy a put option this is called a collar trade. The result is that you return can only be within a small window – a collar. So you are not risking all of your capital on the one position.

If you are a buy and hold share investor then you do not need to worry about these more advanced strategies for now. What you can do today is start earning regular income from your share portfolio without having to wait for your annual dividends. A pot of gold awaits you.

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