Options strategies can help investors achieve goals that stocks alone can't. One common question involving options is whether you can generate extra income from your stock holdings. There is a strategy that you can use to produce option income on the stocks you own, and although it comes with some trade-offs, many find it effective. Let's take a closer look at what's known as the covered call strategy.
Options don't pay actual dividends
First, it's important to understand that in strict terms, options don't pay dividends. Even if you own an option to purchase stock, you don't receive the dividends that the stock pays until you actually exercise the option and take ownership of the underlying shares.
However, some investors sell call options on stocks they already own in order to generate income. The call options you sell give the buyer the right to buy your stock at a fixed price within a certain amount of time. This is called a covered call strategy because in this situation, you own the underlying stock that you will use to cover your obligation to deliver shares if the option buyer chooses to exercise the option.
Two scenarios for the covered call strategy
Typically, the covered call strategy involves selling options that allow the buyer to purchase your stock at a price that's higher than the current market price. As a result, the strategy can generally work out in two different ways. If the stock stays below the agreed-upon payment price for the stock under the option -- also known as the strike price -- then the option buyer won't exercise the option. In that event, the option expires worthless, and the money that the buyer paid you for the option is yours to keep. That's what many investors refer to as the dividend-like income boost from the covered call strategy.
But the trade-off is that there's the danger that the stock will rise well above the strike price you agreed to in the option. In that case, the option buyer will exercise the option, and you'll be obligated to sell your stock at the agreed-upon strike price. That will be less than you could get in the market, and so you'll have missed out on the opportunity to sell your shares in the open market at a higher price.
Note that you still get to keep the money you received when you sold the option, which can at least partially offset the lost profits. In addition, if you set the strike price high above the current market price, it means that you'll have enjoyed a nice capital gain on your shares before selling them.
Many people use the covered call strategy as a way to generate income. Even though it's not typically a dividend, the proceeds from option sales that you receive gives you a stream of income that meets the same purpose for many investors.
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