Mention the term "stock option" and most investors generally think of two things: outsized executive compensation pay packages or something that's the equivalent of a financial Rubik's Cube -- too complicated to bother with. Below, I'll describe a straightforward option strategy to boost income from your portfolio; it'll even allow you to construct a dividend for shares that don't pay one!
What are options?
There are two basic types of options: calls and puts. In this article, I'll focus on an income strategy that involves call options. A call option gives the owner the right to buy a stock at a predetermined price (the "strike price") before or on a set date (the "expiration date"). (For reference, put options give the owner the right to sell shares at a predetermined price within a set timeframe.)
Here's a concrete example: If you buy the $100 June 2015 call on Facebook (NASDAQ:FB), you've purchased the right to buy one hundred shares of Facebook at $100 per share at any time between now and the option's expiration date on June 19, 2015.
With Facebook's stock currently trading near $75, there would be no point in exercising that right immediately -- you'd be better off buying the shares in the open market. However, if the stock were to rise to $120, you can see how the right to buy it for $100 would be valuable.
Creating your dividend with a covered call
Now imagine that you already own 100 shares of Facebook shares and that, instead of buying the June 2015 $100 call option, you sell that option, pocketing the market price of the option, known as the option "premium." This combination of the long stock position and the sale of the call is known as a covered call and it's an income-generating strategy. Let's examine how it works.
If Facebook's stock price remains below $100 until the expiration date, the option buyer will not exercise his option and the premium you received upfront is pure profit (it's not riskless, however, as we shall see in the next paragraph). On Thursday, that option last changed hands at $1.50 (one option gives the right to buy one hundred shares, but the option price is quoted on a per share basis), so if we relate that to Facebook's closing price of $74.11, it represents a 2% return. Under that scenario, you've effectively created a 3.2% dividend (annualized) on your Facebook shares (not bad if you consider the dividend yield on the S&P 500 (SNPINDEX:^GSPC) is 2%).
There is a trade-off, however. In exchange for the option premium you received upfront, you have forfeited the upside beyond the $100 strike price on the Facebook shares you own. Indeed, if Facebook's stock rallies above $100 before the expiration date, the option buyer is likely to exercise his right to buy the shares at $100 and your shares will be "called away." Your profit on the shares over the life of the option is capped by the $100 strike price. (The strategy is known as a covered call because the possibility of the options being exercised is covered by the shares you already own.)
Two options for Foolish investors
In general, we Fools do not like to cap our stock profits -- that's the whole point of being long-term, business-focused investors. However, for an active, engaged investor, a covered call can still be a Foolish strategy: Perhaps you feel that Facebook's stock would be significantly overvalued at $100 and you'd be happy to sell your share at that price and move on to more attractive opportunities. In the meantime, you're happy to pocket your "dividend." Still, this is only appropriate for active investors who have the time and inclination to carefully supervise their portfolios.
For investors looking for an easier route to generating income from their portfolios, there is no better starting point than stocks that -- unlike Facebook -- actually pay a dividend. You won't necessarily need to sacrifice growth, either: According to an underrated paper by money managers Rob Arnott and Cliff Asness, "the historical evidence strongly suggests that expected future earnings growth is fastest when current payout ratios are high and slowest when payout ratios are low." Between above-average earnings growth and dividend income, no wonder high-quality dividend stocks are such effective wealth-building machines.
Alex Dumortier, CFA has no position in any stocks mentioned. The Motley Fool recommends Facebook. The Motley Fool owns shares of Facebook. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.