Passive income…You own a financial instrument or “real” property to eventually profit from its sale, but also make ongoing income from it. The two most common examples are:
Covered calls are like collecting rent on real property. You own shares of ABC stock, letting you safely sell a call on ABC to someone who thinks ABC is going up. For example, you own 100 ABC shares currently priced at seventy. If you sell an ABC 75 call, expiring May 21st, the buyer has the right to buy ABC shares at the strike price (75) anytime between the purchase date and May 21. This is referred to as “exercising” the option. This right is a choice to buy ABC at 75, but not an obligation. That choice exists for a limited, specified time span, ending at the option expiration date.
A call becomes worthy of exercise if ABC’s share price exceeds the strike price, since why would you buy ABC for the $75 strike price if it’s selling in the open market at $72. (there’s one situational exception we won’t go into now).
The call-buyer benefits if ABC’s shares rise enough before the expiration date (technically reaching 75 + the amount paid for the call), either:
As an ABC covered call seller, you are obligated to deliver ABC shares if the buyer elects to buy them using the call that was bought. Your aim is not to have to do this, but you must be ready for the contingency. The option premium you received is payment for this obligation. But already owning the shares, you’re set.
If by the end of the contract ABC doesn’t reach its strike/exercise price – rises only “a bit”, stays flat, or falls the call becomes worthless. The buyer’s premium is lost and since generally the market is a zero-sum game (it is here), as the seller you win. That’s the aim of the covered call.
Selling covered calls is great due to an option being “a wasting asset, i.e., part of what gives an option its value is how much time is bought for the contract life. But as the time passes, the time value degrades and evaporates. So as the seller you keep the premium if the price of ABC doesn’t reach the contract/exercise price by the specified date. All the while the call you sold is losing its time-value as days and weeks pass.
As anyone who has ever bought options has learned, it’s not enough to be right about a stock direction prediction; it also has to be right IN TIME. That is why for most people buying calls tends to be a losing exercise. If call buyers are generally losing, then call-sellers (who know what they’re doing) are generally winning.
What’s bad for the call-buyer is good for you as the seller, since in a perfect world the option is worthless when it expires. Or, if you want to buy the option back early (there are reasons to sometimes do this), you can do it at a much lower price, keeping the difference between the higher price it was sold and the lower price it was bought back for to close the position.
A savvy trader or investor owning ABC stock can sell ABC calls several times/year, even every month or more often, and collect premium, i.e., extra income. When done intelligently and without greed (trying to collect too much at one time), this can be very profitable with a bit of attention.
Below is a recent example of a typical, no-drama covered call with an unexciting blue-chip stock, Coca Cola (KO). The stock as of 2/22/21 pays a quarterly dividend of 0.41/sh. This position shown, lasting about a month, collected 0.47/share in premium. This monthly premium is equivalent to about 14% more than the three-month dividend (0.41). Over a quarter the call premium is equal to a bit under 3 ½ extra dividends.
Done properly, covered calls are highly beneficial when not “trying to do too much.” They actually
can’t fail” in terms of suffering an actual loss on the option trade. Doing them properly avoids having the stock needlessly called away, resulting in undesirable, associated tax consequences.
In the example, KO’s price never reached its strike/exercise price (53). The option lost its entire value and we kept the premium received when we sold the covered-call.
So, covered calls are a great passive income strategy when you own shares of stock or ETFs.
But...what if you don’t own shares of stock, which are needed for covered calls?
How can you get some of the benefits of selling calls just described, without owning shares and without laying out money? We’ll start talking about that technique, called credit spreads, in Part 2.
Robinhood is facing backlash for appearing to aid institutional investors over individual traders after the popular investing app blocked users from purchasing shares in GameStop and other companies that experienced a price explosion in January.
GameStop’s share price shot up from about $30 in early January to more than $300 last week as retail investors drove up the price against hedge funds and other institutional investors. Institutional investors had previously shorted some 140% of GameStop’s existing shares on the assumption that the security would decrease in value.
According to data compiled by The Box, Robinhood earned about $675 million in revenue after sending the customer’s orders to “market makers.” Many of the “market makers” are hedge funds or other institutional investors, according to the Financial Times.
Trades on Robinhood are commission free. But to generate revenue, trades are sold to “market makers” who often use their position as the middle man to generate a profit off the information received from Robinhood.
For example, when you buy a share of Tesla on your phone, Robinhood sends that order to a trading giant like Citadel Securities and receives a few pennies in return. Citadel, meanwhile, completes your trade and makes a few pennies itself.
Robinhood has long branded itself as an accessible platform that provides free financial services for its users. Its mission statement includes a pledge to “democratize finance for all.” But the company makes money by selling its order flow — information about user transactions — to third party clients who actually enact trades with access to user data.