Many of us own stocks through retirement portfolios or in our own market speculation, but very few are capitalizing and generating any income on stocks that they already own.

Covered calls are a relatively new idea to many investors mostly because they’ve never heard of them. Covered calls are simply stock options that you sell on shares of stock that you already own. By writing your own options, you’ll be able to sell stock options and pocket the premium for each.

Introduction to stock options

When an investor purchases stock options, they are not buying stock, but rather the ability to buy stock at a certain price before a specified date in the future. Stock options are similar to a down payment on a contract; the premium price is paid for the right to buy stock from you in the future. If the shares do not reach the target price, the investor does not have to exercise his or her options, and thus, can let them expire.

By writing covered calls, you are selling the option to buy your stock. Consider this scenario: you own 500 shares of Yahoo stock at $20 per share. To generate an income, you sell call options with a $25 strike price two months in the future. By doing so, you’re essentially betting that your Yahoo stock will not appreciate in value by 25% over the next two months, and you’ll be able to collect the premium price of the option. Currently, the premium for a $25 strike price two months in the future is $.52 per option, or $52 per lot. By selling covered calls on 500 shares, you’ll generate an income of $260 instantly.

There are some risks to writing covered calls

There are risks to selling covered calls. In that case that Yahoo stock rises to $27 per share, the options will be exercised and the current owner will be able to purchase your shares for $25 per share even though the current market value is $27. You’ll receive a total of $25.52, the premium price plus the strike price for your shares and incur a $1.48 difference on the amount you could have made without selling the covered calls. Of course if the stock price rises only to $23 per share, the owner of the options would not exercise them and you’d be left with 500 shares worth $23 per share and the option premium of $.52 each.

There are many different variables to consider when selling covered calls. Higher strike price values warrant lower option premiums, while lower strike prices bring higher premiums, but a greater risk that the stock price will rise, and thus, end up losing your shares for a price lower than current market value.

Writing covered calls more frequently generates more money

Selling covered calls on a month to month basis (or every two months to minimize commissions) rather than long term one-off options will generate a higher return from your shares of stock while allowing you to raise and lower the strike price as the stock values change. The difference is that short term covered calls require more work as you’ll be writing covered calls each month, rather than every three months, six months or two years. In the case of the Yahoo stock mentioned above, you’d be able to generate an income of $4.42 by selling calls worth $.52 every two months for 17 months, or just $2.70 selling covered calls one time 17 months in the future.

There are some restrictions

Covered calls can only be sold in lots of 100 options and must be backed by your own ownership of the stock. Selling covered calls also means you’ll be paying some commission to execute your orders; this varies from broker to broker, but is usually about the same price as buying and selling options.

Other than these two notes, there isn’t much holding you back from writing covered calls and generating an income. In the example above, just 500 shares or $10,000 of stock can generate $520 in premiums in less than two months. Unless the stock rises 25% in that time period, the premium is entirely yours to keep without having to sell your stock.

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