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How to 'Rent' Your Stocks for Extra Cash Each Month

By Costas Bocelli May 19, 2011 Facebook Logo Twitter Logo Email Logo LinkedIn Logo

Editor's Note:  Costas is out today, and will be returning next week.  Please enjoy the below article, originally published in April, 2010.
If you were a real estate investor who owned an apartment building, you would never try to leave your apartments vacant.  Every time someone moved out you would try hard to rent it to someone else to keep generating steady cash flow each month.

Did you know that you could do this with your existing stock positions?

Consider, for a moment, all of the stocks you bought (and still own), believing they would go up in price.  As often happens, not all stocks move as quickly or as much as you would like them to.

This is when you can use these shares that are experiencing slow or stalled growth to generate additional returns with covered calls.

What is a “Covered Call”?

A call option itself is a contract that gives the buyer the right to buy 100 shares of the underlying stock from the seller, and obligates the seller to sell 100 shares of stock to the buyer.

A "covered call" is a way to use call options as a method of leasing your stock position.  What you would do is to simply sell a call option against existing shares of stock you currently own.  The term "covered" means you own shares of stock to cover the call option you are selling.

How to Execute this Strategy

Let’s assume you own shares of Time Warner (SYM: TWX) that you bought at $25 per share six months ago.  Although the stock has moved modestly higher in recent months, you think it might start to slow down and hover in the $33 range for a while.

Since you do not want to close your position and you still want to use this stock to create as much profit as you can, you will look at the listed call options to consider a covered call strategy.

Since TWX is trading at $33 per share, let’s say you sell a July $34 call option contract.

What does that mean?  It means that:

(1)  The buyer of this contract pays you a premium of $1.25 per share for selling this call, which will be immediately deposited into your brokerage account.

(2)  The buyer of this contract has the right to buy this stock from you at $34 per share through the 3rd Friday of July.  And just like any contract, you are obligated to sell your 100 shares of TWX if the buyer decides to exercise his or her right to buy the stock.

Now imagine that TWX is trading at $36 at expiration.  The buyer of your option has the right to purchase the stock from you at $34.  With the current market price of $36, if the buyer bought your shares at $34 and sold them back to the market at $36, the buyer would yield a $2 profit on the stock.

Remember, however, that the buyer paid you $1.25 per share just for the right to do this.  So that $1.25 premium he paid to you has to be subtracted from the $2 profit on the stock, bringing his net profit on this trade to 75 cents.

Now let’s look at this trade from your perspective.

What if TWX remains at its current price at expiration?  In other words, you were right about Time Warner, and its stock was exhausted after its recent run.

If the price is $33 per share, the buyer you sold the contract to would have no incentive to exercise the option and buy the stock from you.  There’s no reason to pay you $34 for a stock that’s currently trading at $33 per share.

What would happen is that the option would expire worthless and the premium you collected is yours to keep: the $1.25 per share in premiums you received to enter into the contract is added to the profit you already have from owning the stock before its recent run.

What if TWX is trading at $36 at expiration?  In other words, you already own the stock from $25 per share and have held it for six months already.

If you fulfill your call obligation to sell the stock and sold it for $34, you would have made $9 in profit on the original trade ($34 - $25 = $9) plus you would have made an additional $1.25 in profit from the premium you collected, increasing your total profits by 5%.

Another added benefit to this strategy is your downside protection.
  The premium you receive in this trade brings your cost basis for the trade down, meaning you can weather some price movement to the downside without losing ground in the trade.

Going back to the example, if your original cost basis is $25 and you are paid a $1.25 premium, your new cost basis, or breakeven point, drops to $23.75 ($25 - $1.25 = $23.75).  If TWX pulls back to $23.75, your $1.25 premium offsets this loss in the stock price and you are still breaking even on the trade.

Selling covered calls can help you generate consistent streams of income while at the same time offering you downside protection.

But here are a few key points to remember ...

1.  Aim for selling calls month to month when appropriate.  This will bring cash into your account every month.

2.  Make sure you don’t limit your upside.  If you expect the stock to move increasingly higher, a covered call will allow you to profit only up to the strike price you are selling.  Covered calls are not appropriate for all stocks.

3.  Don’t use this strategy on stocks you aren’t willing to sell, because you might be required to sell.

4.  Don’t use this strategy to rationalize holding on to a bad stock.  If you see the stock moving below your breakeven point, research the condition of the company to ensure it's worth owning.