Have you ever found yourself wishing that your favorite stock paid a dividend… or maybe even wishing that your dividend stock paid you a bit more?
Well, there’s actually a way to generate income from your shares of stock above the company’s normal dividend.
You can even use this same strategy to generate income from stocks that don’t pay investors anything.
I learned about this strategy when I first started my job as a research assistant for a local hedge fund.
My mentor Bill had a large stock position that he held in his personal account.
The stock was special to him because he earned it as a partner of an investment bank. When that bank went public, Bill’s partnership was converted into shares of stock.
Bill used the strategy I’m about to show you to collect hundreds of dollars each month from those shares.
And during the time I worked under Bill’s guidance, I watched him collect tens of thousands of dollars in his personal account.
Bill was using the “covered call” strategy, which is a very safe way to sell options contracts to get extra cash from shares that you own.
Here’s how it works…
Selling Covered Calls for Income
As the name implies, a call contract is a contract between two traders.
This agreement gives the owner (or buyer) the right to buy shares of stock at a specified price. And the writer (or seller) of this contract has an obligation to sell shares at that price.
Each call contract has a strike price (the agreed-upon price to buy or sell the shares of stock) and an expiration date (contracts are only valid for a limited time). Each contract represents 100 shares of stock.
Here’s how to use a call contract to generate extra income from your favorite stock.
Let’s say you own 100 shares of Verizon Communications (VZ), which is trading near $55.
The company pays a quarterly dividend of $0.628, which adds up to a 4.5% yield. But you can get even more income with our covered call strategy.
Right now, you can sell a June $57.50 call contract for $1.05 per share.
To be clear, you don’t have to own the call contract before you can sell it.
When you sell a call contract, you’re simply entering an agreement to potentially sell your shares of VZ at $57.50 when the call contracts expire on June 18.
By agreeing to sell your shares at a price above where VZ is trading today, you’re given a payment that’s much larger than the quarterly dividend VZ pays its investors.
Plus, if VZ pays a dividend while you’re holding your shares, you’ll receive that payment as well.
Here’s What Can Happen…
Once you sell your call contract, the buyer of the contract has a right to buy shares of VZ from you at $57.50.
Typically, this right would only be exercised on the final date. So you’ll most likely continue to hold your shares through the close on June 18.
If VZ closes below $57.50 on June 18, the call contract will expire. You’ll get to keep the income you received from selling the call contract. And you’ll also keep your shares of VZ.
Think of it this way: the owner of the call contract wouldn’t want to buy shares of VZ from you at $57.50 if they could buy shares of VZ cheaper in the open market.
So if VZ closes below $57.50, the call contracts simply expire and disappear from your account.
On the other hand, if VZ closes above $57.50 on June 18, the owner of the call contract will likely exercise their right to buy shares.
So you’ll be obligated to sell your shares of VZ and your broker will automatically handle the transaction in your brokerage account.
Keep in mind, $57.50 is above where the stock traded when we sold our call contracts.
So you’ll have made an extra profit on your shares. And you still get to keep the $1.05 per share that you received from selling your call contract.
So in this case, it’s a win-win.
You sell your stock at a higher price. And you receive extra income from entering your call contract.
I’m sure you can see why this is a great way to earn extra income from shares you already own.
Before you try this strategy on your own, I have a few pointers…
Some Things to Keep in Mind
There are a few things you need to understand before trying this strategy out in your account.
First, remember that every call contract represents 100 shares.
So be sure to sell one call contract for every 100 shares of stock that you own.
I never recommend selling call contracts without first owning the stock (and most brokerage accounts won’t let you do this anyway).
Second, you need to understand that when you sell a call contract, you’re giving up the potential for much larger gains.
Basically, you’re accepting income right now. And in exchange, if the stock trades sharply higher, you’re giving someone else the chance to buy it from you at a fixed price and sell it in the market for a higher price.
In many cases, the income you receive is much more attractive than some hypothetical gain in the future. But just know that this is the tradeoff that you’re making.
Finally, if you decide that you would rather not sell your stock, you can always buy back your call contract.
Simply use the “buy to close” function in your brokerage account and buy the exact same call contract that you sold originally.
If your stock trades higher, you may have to pay a higher price to buy the call contract back.
But if that’s the case, you’ll probably already have made more of a profit on your stock position than you lose buying your call contract back.