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Passive income is the best kind of income because you get paid no matter what you’re doing at the time — traveling, working your day job, enjoying your hobbies, etc; it doesn’t matter, you still receive the income. Earning interest is an example of passive income. So is collecting dividends. What’s not to like? The good news for anyone who owns stocks or ETFs is that there is another kind of investment that is passive in nature and easy to implement — called covered calls.

A “call option” is an agreement between two investors. It gives the purchaser of the option the right to buy stock, while the seller then has the obligation to sell stock. Both parties agree in advance on the price (called the strike price) and on the duration of the option (options expire on a known date, called the expiration date). The buyer of the option pays money (called ‘premium’, or ‘option premium’) to the option seller. If the buyer decides he wants to exercise the right granted to him by the option, then the seller is required to sell the shares at the strike price.

As an example, let’s say Bob wants to buy 100 shares of XYZ for $50 between today (December) and 3 months from now. Bob buys 1 call option on XYZ stock with a strike price of 50 and an expiration date of March (for example). Let’s say XYZ is trading for $45 today and so Bob might pay $100 for the right to buy XYZ at $50 between now and March. He does this because he thinks XYZ will rise above $50 between now and March. If XYZ shoots up to $60 then Bob can exercise his right and force the seller of the option to give him 100 shares of XYZ at the strike price ($50/share). Bob has to pay $5000 for these 100 shares. He can then turn around and sell the shares in the open market for $6000, pocketing $1000 (less the $100 in premium he paid to the seller when he bought the call option). However, if XYZ finishes below $50 in March then Bob’s option expires worthless and he loses the $100 in premium he paid.

Selling call options to other people is a good way to earn recurring income. However, you only want to do it with stocks you already own. Because if the options you sold are exercised you already own the stock needed to deliver your end of the deal. That’s why it’s called a ‘covered call’… your obligation is covered by the stock you own at the time you sell the call option. If your stock is called away then the worst that can happen is you receive the strike price per share for every share covered by the option (and you can set the strike price as high as you like when you sell the option).

Many people use covered calls to create monthly income. It is a passive investment strategy where you can collect option premium each month. If one of your stocks rises above the strike price then the option buyer may exercise the option and pay you for your stock. You still made money, but you may not have made as much as you could have if you hadn’t sold the option. On the other hand, the option premium that you’ve been collecting each month provides current income and some downside protection should your stock drop in value during the life of the option. Covered calls are the most popular of all option-based strategies and are easy to learn and sell.

If you want to know more about covered call trading you are welcome to visit Born To Sell. Covered call options for dummies could be the name of the free investment tutorial at http://www.borntosell.com/covered-call-tutorial/covered-calls-for-dummies.

Tags: options, invest, wealth building

Tags: finance, income, invest, investing, investment, investors, money, option, options, stock, stocks, wealth building