Suppose you own an individual stock, or an exchange traded stock index fund. You don’t want to sell the stock, or fund, unless it goes up a bit more, but you would like to find a way for your investment to produce investment income for you.
One choice you have is to sell, or write, covered calls. Here’s how it works:
Suppose your stock or fund is valued at $10.00 per share. You draw up a contract (actually it all happens online where a brokerage firm is drawing up the contract), called a covered call option, that says you are willing to sell 100 shares of your stock or fund if it goes up to $12 per share.
Someone buys this covered call contract from you. They are buying the right to buy your investment at $12 a share within a pre-agreed upon amount of time. They are buying your covered call because they think there is a chance the investment will go to $14 a share. They can then “call” it away from you at $12 a share and make a quick profit.
You sell the covered call because they are paying you for it. You earn investment income when the covered call is sold. If your investment does not get called away from you, you pocket the income. If the investment does get called away from you, you still pocket the income, but now you have to forego any additional gains.
Covered calls can be used to produce consistent investment income on a portfolio of stocks or exchange-traded funds, but you have to know what you’re doing. You can also buy closed-end funds that use covered call strategies, or hire an investment manager that specialized in covered call strategies.
