How to Create Passive Income from any Stock
Updated: Sep 5, 2019
Create passive income from stocks you own by selling covered calls for premium income. This can add $1,000s of monthly income to your cash flow while protecting from stock price downturns.
We have discussed the importance of using monthly dividend stocks to create passive income. Our previous post designed a plan to diversify income investments in stocks with 20% dividend yields. There are other strategies to add passive investing income to your portfolio. If you own 100 shares of a stock,then you can sell a call option to receive a cash premium. In general, you can make 3-5% per month in extra income from this strategy.
There are several styles of covered call writing. Some investors never do more than write calls on their portfolio stocks that can be an art within itself. Many investors buy stocks for the express purpose of writing covered calls on them and then sell the stocks or let them be called away at expiration. There are covered call strategies for the active trader who seeks action, for the shoot for the moon directional trader, for the lazy writer and for those with a long-tern horizon. Then the conservative crowd are fearful of risk and seeking low-risk or limited-risk trades.
As an investor, you can have covered call your way. No matter your lifestyle, if you have a computer or smart phone, there is a covered call strategy that will work for you. Is it riskless?
No – but there are ways to lower your risk in the trade like insuring the trade.
If you are an investor interested in creating income streams. Then, covered call writing should be part of your portfolio. You can write calls against your dividend stocks to enhance your income. I like to think about covered call writing as a monthly income stream.
I can sell a call option each month on a stock I own. This premium income is automatically deposited into my account at the transaction completion. Now, do this every month for a year. Then, add up the amount of the premium income for the 12 months and divide it by the purchase price of the stock. Compare this calculated covered call yield to the stock dividend yield. Which is higher? Typically, the stock dividend yield may be 3-5% but the covered call yield will be 15-20% yield.
For an income investor, a call yield this high is a great stream of income and it provides some downside price protection. Using the “rule of 72” will result in doubling your investment in 3.5 years. Even better, you can add $1,000s of income each month to a medium size portfolio.
The theory of covered call writing explained here should catch the eye of the income investor. This clearly shows why covered call should be a lifestyle-making portion of your investments. We like to sayCovered Calls for Life is where it is at for multiple streams of income.
What is an Option?
An option is a standardized contract originated by the Options Clearing Corporation (OCC) that is exchange listed. A stock option is the legal right, but not obligation, to buy (calls) or sell (puts) shares of a specific stock, which is known as the underlying stock, for a fixed time and a fixed price. Stock options have two main characteristics:
Fixed Price: an option give the holder the right to buy or sell at a fixed price. This price is known as an exercise price or strike price (or just “strike”).
Limited Life: an option is good for only a specific period of time, then expires. If it expires without being exercised, it is said to “expire worthless.”
The Two Types of Options
There are two types of options to be used in your option strategy for various trades based on the prediction of the investor.
Calls: the right, but not the obligation, to buy the underlying stock.
Puts: The right, but not the obligation, to sell the underlying stock.
Buying and Selling Options Primer
Underlying Stock – these are the shares of stock that underlie (are subject to) a stock option. The underlying stock also can be an Exchange-Traded Fund (ETF) instead of a stock.
Option Contract – each exchange-listed call or put contract normally covers 100 shares. The only exception would be for a stock or reverse split, merger or other corporate recapitalization, which can result in an adjustment to the terms of an option contracts. There are over-the-counter options, but they are a different subject and not covered in this article.
Option Trading – standardized options contracts are exchange-listed and traded on the different U.S. option exchanges.
Expiration – stock options (equity options) expire on the Saturday following the 3rd Friday of each month and that Friday is the last day on which those options can trade. If the 3rd Friday is a holiday, the last trading day will be the Thursday before. Some brokerage firms institute a Friday deadline for notice of exercise by retail customers so be clear on whether you can exercise options on expiration day. Be aware that options you have sold can be exercised on expiration day.
Option Term – stock options have a life of 9 months or less unless they are LEAP options with a much longer life, up to three years. At the end of the term, the option expires.
Open Interest – the number of contracts of an option series outstanding. A proxy for how much interest among investors in this contract.
There is no risk that upon exercise of an option the other side will fail to perform. The OCC, the world’s largest clearing organization for options, processes all sales of put and call options and all option exercises. The OCC acts as the guarantor of every option transaction to ensure there are no option defaults.
In fact, there has never been a default in buying or selling shares upon call or put exercise, for this very reason. The OCC does not guarantee anyone a profit, however, only that shares will be bought (sold) upon call (put) exercise. Note that buyers and sellers of options do not form a contract with each other, there contract is with the OCC, which is the true counterparty to the option buyer or seller.
Stocks and Options: Similarities and Differences
There are both similarities and differences between stocks and options. Some think of options as a stock substitute which is correct in some cases. However, it is important to know the differences as you include both in your investing plan.
· Stocks and options are both securities. Options are technically derivatives since they relate to another security: shares of stock.
· Stocks are traded on exchanges and also over-the-counter. Stock options trade only on exchanges regulated by the SEC.
· Market makers buy and sell stock options as they do stocks.
· Stock represent an equity ownership interest in the company. An option is a contract.
· Options expire on their respective expiration dates. An option not exercised by its expiration date expires worthless. Stocks never expire except when a company goes out of business.
· Stocks are represented by stock certificates, although buyers often don’t see the shares because they are held in the broker’s street name. But options are maintained in the form of electronic book entry only, and there are no certificates that represent options.
· At any time, there is a fixed number of shares of stock outstanding. However, there is no limit to the number of option contracts that can be created on a stock.
· Holders of stock have the right to vote and receive dividends, but holders of options have neither, since the option is only a contract to buy or sell.
Moneyness: Option Strike Prices
Stock option strike prices fall into the three categories, depending on their relationship to the stock’s price (known as the “money”). This relationship to the “money” is known as moneyness.
· In the money (ITM)
· At the money (ATM) – this is used to refer to options near but not exactly at the money
· Out of the money (OTM)
Covered Call writing is a great way to add income to your portfolio while diversifying your income. The best way to get started is to subscribe to the Get Rich Monthly Income Plan. this newsletter shares how to setup covered calls for income as well as giving investing trade recommendations each month.
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In case you don’t already have a brokerage account, I have listed sources below. I actually have accounts at these brokerages for my monthly dividend stocks. I like both Robin Hood and WeBull as they have low account setups ($5 to open) with no commissions for buying stock. I like to roll my passive income into these accounts to invest in my monthly dividend stocks for a lifetime living on the Passive Income Monthly Plan. As your account increases,you can also implement covered call investing with stock options.
Plus, you get a FREE stock when you open an account.
Robin Hood – Open an account for $5 to get a free stock. Then, refer friends so you each get a free stock. Invest in stocks, ETFs, options, and cryptocurrencies, all commission-free, right from your phone or desktop.
WeBull - Free shares are valued anywhere between $8 and $1,000, depending on market activity. This is an app-based brokerage on your phone. You can refer friends for additional stock.