Covered Calls

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Selling covered calls is a way to enhance returns on stock you already own.  You are in effect using your stock as rental property, collecting monthly or semi-annual royalties on that stock.  In return, you are agreeing to part with that stock should it come up to a certain price level.  Selling covered calls generates income that also reduces your cost basis on the stock.  Let's say you have own Altria (MO) for years.  It has paid regular dividends, and periodically, you have purchased more shares.  You now have about 500 shares, and would be happy to generate more money out of that stock than mere dividends.  Why not collect some (rental) money while waiting for your money to grow or waiting for the dividends?  It is just sitting in a brokerage account; why not "use" it to enhance your returns.  MO closing price on April 21, 2011 was $26.06.  The December 2011 $27 strike calls are bidding $.75.  If you sell 5 contracts to cover your 500 shares, you will receive $.75 x 500=$375.00 into your account immediately.  The sale of a covered call means that should MO rise to $27.00 by the December expiration, you agree to part with your 500 shares at the strike price of $27.00. 

What could go wrong?  MO could crash.  In this example, you received $.75 per share for agreeing to sell your stock at $27.  That brings the break-even price down to $25.31 ($26.06 - $.75).  But if MO crashes down to, say, $20.00, clearly that $.75 does very little to mitigate that loss.  Then again, with or without selling the covered call, MO could still crash.

Covered calls are a terrific strategy to generate income from range-bound to slightly bullish stocks.