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.