We talk about our love for quality income streams regularly on this website and one example of this is the ownership of listed shares or securities. Not only do shares in a well run listed company offer long growth prospects, share ownership can also offer the payment of dividends. Now there are shares in quality company that don’t offer dividends such as various technology companies however when looking at passive income investments shares that pay dividends are high on our list.
One thing that you may not be aware of is you can “rent” your shares out to others for a period of time and in return earn an income for doing this. This is done by using options, by writing a covered call on your current share holdings.
For the more experienced investors you may know this strategy or even are doing this yourself, for those that don’t know about this strategy, let’s go into more detail below:
*A couple of things to cover off before we get into more detail with this strategy
1. You need an understanding of the basics of options
2. You must be willing to sell your shares in the event your option(s) is exercised
3. You need a broker or trading platform that allows you to use your shares to undertake this writing call strategy.
4. In this post we will be focused on American style exchange traded options (options that can be exercised at any time before the expiry date) rather than European style options (can only be exercised at expiry).
So what is an option and how do they work?
Firstly, an option is the right but not the obligation to buy or sell the underlying security by a certain date at an agreed price. When looking at options for listed shares you can buy (or sell) call options (the right to buy) and put options (the right to sell).
In this post we will focus on selling (writing) call options covered (secured) by your underlying shares. You can buy and sell options as well as write (sell) put options. Trading or investing in options using either of these methods can be risky and should only be done with a detailed option and share trading background. Writing (selling) put options can be a very risky strategy for someone with little to no option experience.
The typical option contract covers 100 shares of the underlying security and the exchange that the option is usually traded on in the U.S is the Chicago Board of Exchange (CBOE). Each option exchange has its own rules for the options they allow however the main requirements are that the underlying security is listed on a large exchange such as the NYSE or the Nasdaq, has several thousand shareholders, that the share has been listed for several months and has a minimum level of outstanding shares (the CBOE requirement is 7,000,000 shares outstanding).
So in effect, most of the large US NYSE and NASDAQ listed companies are suitable for option strategies. You will note that with every option contract the company exchange ticker code, exercise date and strike price are in the contract name. Once you become more familiar with options you will be able to understand the option terms very easily.
Option pricing is a very detailed calculation however value of an options is essentially made up of intrinsic value (difference between current share price and option exercise share price) and time value (how long until the option expiry date). Options are more valuable when there is substantial time before the option expiry date (time value of the option) and/or the option exercise price being below (for a call option) the current share price or above (for a put option) the current share price (intrinsic value of the option).
So how can my shares make me money using options?
This strategy is known as writing covered call options. What this means is that you write (sell) call options to another party offering them the right but not the obligation to purchase your shares by a certain future date at an agreed price.
So if you owned say 1,000 shares in a large listed company you contact your broker or log into your brokerage account and write (sell) 10 options to another party for the right but not the obligation to purchase these 1,000 shares at an agreed price at or before a certain date.
So you need to ask yourself at what price would you be happy with to sell these shares at a future date, say 60 days. Once you’ve found that price and date, that will be your option strike price and your option expiry date.
If the share price rises above the exercise price before or at the expiration date then there is every likelihood it gets exercised. Whilst you will have to give up the shares, you will keep the option premium as well as the gain made in the share price from when the option was written to expiry price.
A couple of points to bear in mind, the further the exercise price is from the current share price the less option premium you will receive as it’s less likely the option will ever be in the money or that your shares will be exercised (claimed) at the expiration of the option contract. Also if you write (sell) a call option that only has a couple of weeks to expiry (and the exercise price is well under the current share price/out of the money) you will also receive less option premium.
That sounds great, what is the catch?
There’s no catch, you just have to be prepared to sell your shares at the expiration date should your option get exercised by the person you sold (wrote) the option to. This will usually happen if the option is in the money (share price is above the call option exercise price). However in this case you will have received the option premium and the increase in share price (exercise price minus initial share price).
Most options expire worthless so there is every chance you will keep the option premium that you received when you initially wrote the call option and if the option expires worthless and you still have you shares, you can do the same thing over and over again until your shares get exercise or you eventually sell you shares.
Ok, show me an example
Let’s say you have 1,000 American Express shares (share price at 9th May 2022 was $161.02) and you wished to enter a covered call strategy for these shares. You would have assessed current economic conditions, short term prospects for American Express and determined that the share price will likely stay under $180 by the end of June and if it did go higher than $180 in this period you would be happy with the profit. Looking at the Yahoo finance page we can see for the
American Express June 2022 Call Options with a strike price of $180 is $4.25, therefore in this example you would receive $42.50 for your 10 American Express $180 June option contracts that you wrote (sold) (excluding brokerage fees).
If you changed your exercise price to $170, the value of the option you could write would be $6 an option (receiving $60 for your 10 option contracts). Whilst these amount don’t seem like much, if you have a significant share portfolio this strategy can be done with all your list shares (provided they reach the option exchange requirements) potentially adding hundreds or thousands a month to your passive income.
Writing (selling) covered calls can be a nice little earner on top of your current share holdings and other passive income streams. Whilst it’s unlikely you will make millions using this strategy (unless you have a lot of shares), it’s a nice additional earner for your portfolio. As mentioned above we recommend you have a basic knowledge of options, a decent knowledge of the share market and of the underlying shares that you own, particularly where you think the share price might go (all things being equal) in the near term.
For more information about options, check out this article.