Imagine yourself owning a nice apartment building in a nice neighborhood. You have no tenants, you have no plans to get tenants, and you hold onto the building hoping it will appreciate enough to earn you a few dollars sometime in the future.
Would you agree that’s not a terribly smart strategy? Most people would, and yet many of them will think nothing of buying a stock, perhaps a valued blue chip recommended by a broker, and allow it to just sit there for years, generating no income whatsoever.
How do you make money on the apartment building? You rent the space. How do you create income from the stock? Basically the same way: You create a contract that gives someone the right to “rent” your stock at a reasonable price for a period of time. Every month you rent that stock you collect a fee.
Short-term fluctuations in the value of the house or stock aren’t important. It’s the rent and the income that matter, not the changes in the market. If you know how, you can extract extra income from those dormant stocks you own…and here’s how you do it:
Use options to “rent” your stocks
Most stocks have publicly traded options. An option gives someone the right to buy your stock at a specified price, for a specified period of time, and you get to set the price and specify the time.
Because you give someone the right to buy your stock under certain conditions (more about that in a moment), he or she will pay you a premium (call it “rent”) for that privilege. It’s not unusual to make 2% or more each month (well over 20% a year) from this strategy. Which means if you had $100,000 in stocks you could generate $20,000 or more in income each year instead of just letting your money sit there.
That’s a lot better than what you might expect to earn from dividend payments or money market interest. And it’s a very conservative way to generate income, much safer than just holding the stock alone. With options you can increase your monthly income while reducing your downside risk!
If you’re not familiar with options, you might be wondering why someone would “rent” your stock-pay you for the possibility of purchasing it at some future point-instead of just buying the stock from the outset. It’s because that person is speculating that the stock price will rise dramatically over the period of time for which the option is sold.
If the stock falls or doesn’t rise, the speculator relinquishes the “rent” or option premium and moves on, happy that he had only a small cash outlay compared to actually purchasing the stock. And you keep the premium, which you get upfront in an option transaction, as well as the stock. Then you get to “rent” the stock all over again,
How to make money from options
Every investing strategy has plusses and minuses, but the truly great thing about options-particularly the conservative Covered Call strategy we’re describing-is that you’re in position to minimize any negative impact and emphasize the positive.
On the minus side, you give up the possibility of large upside gains from your stock and you have to take action each month to sell the option; you must stay on top of this strategy.
On the plus side, the value of your total assets will fluctuate less, you generate income each month, and you enhance your downside protection with the income you receive. Here’s how a Covered Call works:
Let’s assume you have 1,000 shares of Hewlett Packard (HPQ) stock, and the stock price is $31.18 on February 10, 2006. You can “rent” your shares to a speculator for 36 days for $750. That means the speculator has the right, until March 18, to buy your stock at a price you select, in this example, $32.50 (also known as the strike price). In investing terms, the transaction would look like this:
Hewlett Packard (HPQ) @ 31.18 on 2/10/06
Options March $32.5 @ .75 (36 days to expiration on 3/18/06)
If the stock price stays the same-at $31.18 until March 18-you would keep the $750 premium (your “rental” fee from the speculator) and you would have no further obligation to give up your stock because your rental contract expires worthless (i.e., the stock didn’t reach the strike price). So in 36 days you’d have a return of about 2.5% on your stock and you could sell the option for another month. Actually, you could continue this type of transaction, month after month, until you sell the stock.
If the stock price goes up to, say, $33.00 by March 18, you would keep the $750 fee. But since the stock went over the $32.50 strike price, you’d be obligated to sell it at that strike price. So you would have:
a. collected the $750 fee (2.5% return)
b. made a small profit on the sale of the stock, from $31.18 to $32.50
(4.3% return)
c. had a total return of 6.8% on your stock in 36 days
What you don’t do is participate in the price appreciation over the $32.50; the additional $0.50 a share over the strike price goes in the speculator’s pocket. Even if the stock had gone to $35 or $40, your participation would have been only up to the $32.50 strike price you selected.
If you wanted to continue to hold the stock, you could repurchase it after it was sold at $32.50 (at current market rates) or you could attempt to buy the option back before it expired, canceling your obligation to sell the stock. If you anticipate that the stock might rise considerably over $32.50, don’t rent the stock that month.
[Editor’s Note: I don’t have a crystal ball. I simply write the option every month and try not to speculate on a stock price rise. I’m perfectly satisfied to draw a return of 6.8% in just 36 days. Think of Covered Call investing as being the “house” in a Casino: while the speculators (or gamblers) are looking for the big hit-and losing most of the time-Covered Call investors are content with taking a small profit from the transactions.]
If the stock price goes down to, say $30, you would still keep the $750 fee, and the stock would still be yours since the speculator would not want to pay the strike price of $32.50. Then you could sell another option after the first one expires on March 18.
By selling the $750 option, you give yourself some downside protection against a drop in the price of the stock. Instead of losing $1,180 in value (1,000 shares times the $1.18 drop in stock price), you’d lose only $330 in value because you keep the $750 option fee. Of course, if the stock continues to fall, you would have been better off selling it instead of optioning it.
[Editor’s Note: In case you were wondering: Strike Prices are set by options exchanges in increments of $2.50, $5.00, or $10.00, depending on the price of the stock. The HP stock used in this example could have had strike prices of $27.50, $30.00, $32.50, and $35.00. There could be a dozen or more for higher priced stocks. You always select the strike price you prefer.]
Put your assets to work!
Why would you just let your money sit idly on the table, when you can be generating income from it?
Using the conservative Covered Call strategies-also known as a Buy/Write-you sell an option against a stock you already own or purchase. The stock is collateral for the option, and the option creates an obligation to deliver the stock if the stock rises over the promised price.
How safe is this strategy? Most online options brokers consider Covered Calls safe enough to allow you to do it as part of your IRA account. And why not? Statistically, most IRA accounts are in money funds, generating a few percent a year, while a Covered Call strategy with those same funds can earn you a few percent each month.
Your question shouldn’t be whether or not to use Covered Calls for retirement (or other) accounts; it should be how do you determine which stocks offer the most downside protection or greatest returns? Top investors use the stock investing research and tools available through Power Options…and now you can, too.
Check out PowerOptions (or call toll-free in the USA 1-877-992-7971) and try our 14-Day FREE PREVIEW to get the answers to your options questions…and to make sure you’re not leaving money on the table!
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