Note: This article is part three in our series on alternative income strategies. Please also read:
- Part I: The Single Best Method For Collecting Investment Income
- Part II: 3 Examples Of Collecting Income On Bullish Stock Ideas
To begin this series, we discussed a strategy for collecting income from stocks that you would like to own. If you're not familiar with this income strategy, I suggest you start with Part I of this series.
Today, I want to show you a similar strategy to collect extra income from stocks you already own. This strategy can give you income on top of the current dividends you receive from your position. And even if your stock doesn't currently pay dividends, this strategy still works to put regular income payments in your investment account.
So let's jump in and see how this additional strategy works...
Strategy #2: Selling Calls on Stocks We Already Own
Our second way of collecting income in our investment accounts is through selling call contracts on shares of stock that we already own.
Remember, the owner of a call contract has the right to buy (or "call") shares of stock from the other trader at an agreed upon price. Since we are selling the call contract, we're accepting the potential obligation to sell shares of our stock to the other trader - but only if he "exercises" his right to buy these shares from us.
Every time we sell a call contract, we immediately collect money for accepting the obligation to sell our shares of stock. This income is paid to our account whether we wind up selling our shares of stock or not.
So just like when we sell put contracts, the money we receive from selling our call contracts is legally ours no matter what. The payment from entering this agreement is deposited into our account and is available to spend - or to re-invest in other opportunities.
Call contracts also have a limited life span with an expiration date. The trader who buys a call option contract from us will have to choose whether to exercise his right to buy shares from us before the expiration date. After that date, the call will "expire" meaning that his right to buy shares (and our obligation to sell them) will go away.
Only Sell Calls Against Stocks You Can Part With
When we sell a call contract, we have an obligation to sell shares of stock if the other trader chooses to buy them from us. So we only want to sell call contracts on stocks that we are willing to sell.
If you have shares of stock that were passed down from your grandparents, which have been in the family for generations, you may not want to sell call contracts. After all, you could be obligated to sell your shares, which you would rather keep in your account.
Some investors have shares of stock, which have a very low cost basis. If these shares were sold today, the transaction would trigger a massive tax liability, which would be difficult to pay.
The thing to keep in mind is that if selling shares of stock at the agreed upon price would trigger a hardship or otherwise cause a problem for your investments, you should probably not sell call contracts for income.
But if you are willing to sell your shares of stock, selling a call contract (and receiving the money from that contract) is an excellent way to collect extra income in your investment account.
Only Use an Attractive Strike Price
The "strike price" for our call option contracts is the price we are agreeing to sell our shares of stock at - but only if the buyer of the call contract chooses to buy the shares from us at that price.
Since we will have an obligation to sell shares of stock at this specific price, it is important to only pick call options that require us to sell our shares at a price we are happy with.
If you own a stock that is trading at $47 and you would be happy to sell it at $50, then it may make perfect sense to sell a call option contract with a strike price of $50.
But if you are not willing to sell this stock for less than $55, then you shouldn't sell a call contract with a strike price that is less than $55.
Simply keep in mind that when you sell a call contract, you have a potential obligation to sell shares at the strike price for that call contract. So before selling the call, make sure you really are willing to sell your shares at that agreed upon price point.
Two Potential Scenarios
Just like the put contracts that we sell, each call option contract has a limited life. Once the time period is up, the contract expires and the agreement between traders is over.
Call contracts typically expire on the third Friday of each month. So if you sell a September call contract, it will expire when the market closes on the third Friday in September.
As a general rule, we like to sell call contracts that expire in a four to eight-week time period. This usually gives us an attractive amount of income, while limiting the amount of time that our obligation will be in play.
When the call contracts that you sell expire, one of two things will likely happen.
- The calls will expire worthless
- The calls will be "exercised"
Let's take a look at what each of these scenarios look like.
Our Call Contracts May Expire Worthless
When we get to the expiration date for our call contracts, our shares of stock may be trading below the agreed upon price, or "strike price."
In this case, the owner of the call contract would not have an obligation to buy shares of stock from us. After all, he could buy shares of the same stock at a cheaper price in the open market.
If the stock price is below the agreed upon price for our call contracts, the contract will simply expire and disappear from our account. We will be left with our shares of stock and will no longer have an obligation to sell these shares. We will still get to keep the income we received when selling our call contracts. And we will also get to keep any dividends that the stock pays to shareholders since we still own our shares of stock.
This is a good scenario for us, and it gives us an opportunity to collect even more income from the trade. Once the call contracts expire, we can then sell more call contracts against this stock - depositing more income into our account and starting the process over again.
We're usually happy with our positioning if our call contracts expire. But our second scenario is even better...
Our Call Contracts May Be "Exercised"
If the stock is trading above the strike price for our call contract, the call will be "exercised" and we will be required to sell our shares at the agreed upon price.
You can see why a trader who owns the call contract would want to exercise his right to buy shares from us. If the stock is trading at a higher price, he will be able to buy our shares of stock at a discount. So he will have an incentive to buy his shares from us at the agreed upon price.
Remember, we only sell call contracts that require us to sell our shares at an attractive price. Also, we are getting paid to sell this call contract and enter the agreement. So even though we may be selling shares of stock at a discount to the market price, we should still be happy that we're selling our shares at an attractive price and that we have already received income from this trade.
This scenario is great for us because it gives us the maximum possible amount of profit for our trade. (We collect income from selling our call contracts, and then we sell our stock at the attractive price that we agreed to.)
Also, when the call contracts are exercised, it closes out our trade completely. We no longer have shares of stock, we no longer have an obligation, and we get to keep all of the income we have received from selling put options and call options along the way.
A "Steady" Approach To Building Wealth
This strategy of selling put contracts on stocks that we would like to own, and selling call contracts on stocks that we already own, is one of the best ways to consistently build wealth in your investment account.
Each time we sell an option contract, we are collecting income in our account, which is legally ours no matter what. This income adds up over time and allows us to grow our account significantly over the course of a typical year. It is our goal to make an annualized return between 25% and 35%, which is very competitive when compared to other traditional investment approaches.
One of the drawbacks of this strategy is that we never expect to shoot the lights out on a trade.
Since we are selling call contracts that leave us with an obligation to sell shares at an agreed upon price, we will never double or triple our money from a stock that shoots sharply higher over a matter of months. So this strategy is often considered "boring" because it doesn't generate huge returns in short periods of time.
One of the most important benefits of this strategy is that it involves less risk than a typical "buy and hold" investor must take.
Since we are collecting cash income each time we sell an option contract, we're automatically one step ahead of the average trader. And if a stock that we own (or have an obligation to buy) begins to trade lower, our income helps to offset any loss we might have from a decline in the stock.
So while this strategy will never "shoot the lights out" in terms of short-term performance, our "steady" approach to collecting income leaves us with a very enviable rate of return year after year.
Due to the reliable nature of this strategy, regulators allow investors to place these trades in retirement accounts such as IRAs. These accounts are usually reserved for the most conservative trading strategies, so the fact that regulators allow our approach in these accounts is a testament to the strength of this methodology.
In our next installment, we'll look at a few real life examples of call contracts we have sold for stocks that we own. In the meantime, if you would like to see these strategies in action, consider checking out the Growth Stock Income Generator - our service here at Seeking Alpha that gives real-time recommendations to help you put this income strategy to work. You can get a risk-free trial of this service here.
I'll be back to you later this week with examples of call contracts I have sold against stocks in our model portfolio.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.