Covered Calls
One of my favorite ways to generate additional income from investments is to use a strategy called covered calls. This strategy involves owning a stock and selling call options on that stock to generate income.
Here's how it works:
First, you buy a stock or index that you think will increase in value over time. Then, you sell call options on that stock to other investors. When you sell a call option, you're giving someone else the right to buy your stock at a specific price (the strike price) at a specific time in the future.
For example, let's say you own 100 shares of the QQQs, which is currently trading at $316 per share. When looking at the chart, you feel that the QQQs are about to enter a downtrend and you want to give yourself some downside protection or just collect some additional revenue while the stock trades below the 10d. Here is an example from April 11th, 2023:
You can see that the price of the QQQs are right at the 10d with a MACD that is about to turn negative. Now, in reality, I prefer to wait for closing prices since we don’t know yet if this is the start of a downtrend or if there will be some strength mid-day - maybe we close green. However, let’s use this as an example regardless.
So, I want to be conservative and sell some calls above recent highs - maybe around $322. So if I look at the April monthly calls I can see the following:
You might sell a call option with a strike price of $322 that expires later in the month - in this case April 21st. This means that you're giving the buyer of the call option the right to buy your shares for $322 each, but only if the QQQs trade above $322 by the expiration date of the option. Each option is sold in 100 share lots - therefore, if you own 100 shares you can sell one option against those holdings.
In our example, 100 shares of QQQ would cost $31,621. The option we can sell against this underlying holding will give us $2.07 premium per share or a total of $207. This represents an additional gain of .65% it it continues to trade below $322 — you can also think of this as .65% of additional downside protection. The buyer that you sold these options to has made this upfront payment because they believe the QQQs will indeed trade above those levels. This premium is yours to keep, regardless of whether the option is exercised or not.
If the stock price stays below the strike price of the option, the option will expire worthless, and you get to keep the premium you received. You can then sell another call option on the same stock and repeat the process.
If the stock price goes above the strike price of the option, the buyer of the option will likely exercise their right to buy your shares. This means you'll have to sell your shares to them for the strike price, which might be lower than the current market price of the stock. However, you still get to keep the premium you received when you sold the call option, which can help offset any losses you incur from selling your shares at a lower price.
There is also the ability to simply buy back that call option for a loss before expiration so that the underlying stock is not called away if the QQQs do indeed trade above $322.
Because you sold the options for $2.07 you don’t really begin to lose out until the QQQs trade above $324.07 ( $322 strike plus the premium you received). However, if the QQQs do indeed trade above the $324.07 before the middle of April (this options expiration) you don’t get to participate in any of the gains above that $324.07 level. The options you sold will lose money at the same rate your underlying stock gains money - which will make it a wash.
In this case, it might be an ok risk you are willing to take.. Why? Well, that means that in the next 10 days the $QQQs go from $316.21 to $324.07 — a gain of 2.4%.
On the other hand, if the $QQQs never trade above that level you get to pocket the .65% premium and it provides a bit of extra income you otherwise would not have received if you just sat on your stock holdings.
Overall, covered calls can be a useful strategy for generating income from your investments. However, it's important to remember that all investments come with risks, and covered calls are no exception. Before using this strategy, it's important to do your research and make sure you understand the potential risks and rewards involved.
