What are covered calls? "Covered calls" is an options-trading technique, whereby 100-share lots of stocks are "rented out" for a period of time. Let's see how this works.
Suppose you own a house that you would like to rent out for a period of time, say, six months. You charge $900 per month for a total of $5400. At the end of the six months, you either rent it again, or keep it vacant, as you wish. The house is yours to do with as you please, but clearly, it is more profitable to rent it out.
The same thing goes for stocks. Suppose you own 500 shares of Microsoft (MSFT) that you have accumulated over the years. It does pay a dividend, but you believe you can earn more by renting out your stock. What? Rent out my stock? Yes.
Here is how you do it.
First, a few basics. As the name implies, you would be doing "covered calls." Options come in two forms: calls and puts. Here, we are talking about call options, and they are "covered" because they cover stock that you already own. Options, like rent, come with expiration dates. They also are listed by strike prices.
If you wish to rent out your 500 shares of MSFT for the next six months, you would check the options chains (a list of options prices that is available from most brokers), and would pick an expiration date six months hence (as of this writing, the next available expiration month would be April of 2013). Next, the strike price. If you would not mind parting with your stock at $30 per share, you would look at the list of $30 calls expiring March 2013, and you would come up with $2.52. Recall that option contracts cover 100-share blocks, so $2.52 would really be $252 for each 100-share block. Since you own 500 shares in this example, you would be receiving a premium of $1,260.00. Here is where it is slightly different from renting out your house. Selling covered calls is a contract, in which you as the owner of those MSFT shares agree to sell your stock at $30 (your selected strike price) anytime between now and April 2013 expiration. If MSFT is trading below that price by next April, you keep your shares. If it trades above that price by next April, you will sell those shares at $30. For that agreement to sell your shares at $30, you have received $1,260.00, which you get to keep, regardless whether MSFT stays or leaves. Yes, that's correct: The $1,260.00 is yours to keep. If MSFT is sold at $30, effectively, your cost basis in the stock decreases by the $2.52 per share you received, or $27.48 per share.
Let's clarify something here: I mentioned above that if MSFT trades above $30 by next April, it will be sold out of your account. Why is that? Because you entered into a contract to sell your shares at $30, and you were paid for that agreement to sell those shares at $30. That means, whoever paid you for the privilege of buying your shares at $30 would obviously be very happy to buy them from you at the agreed price of $30 if MSFT is trading at $32 on the open market. Conversely, if MSFT is trading at, say, $27 by next April, whoever paid you to sell your stock at $30 would not insist on buying your shares for the $30 agreed-upon price, if he or she can go to the marketplace and purchase the same stock for $27. In that event, not only do you keep the $1,260.00 premium you received, which has reduced your cost basis to $27.48 per share, but you can now engage in a brand new "lease agreement" for the next six months. By the way, the percentage return in this hypothetical case was 8.4 percent for six months.
A nice way to generate steady income.
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