When it comes to making money with stock investments, a buy-hold-sell strategy isn’t your only option. When stocks are not meeting performance expectations, renting your stock position by writing a covered call option is a way to generate additional returns. Although renting stocks isn’t always the right strategy -- and isn’t right for every investor -- it’s an approach many investors use to manage investment risks.
Understand the Risks
Review the risks involved in writing a covered call. Whenever you write a covered call option, which is much like a rent-to-own option in real estate, you face the risk of having to sell if the purchaser exercises a right-to-buy option before the contract’s expiration date. In general, acceptable candidates are stocks you expect to do well and plan to hold over the long-term but whose price per share is presently stagnating or wavering slightly. Although developing an emotional attachment to stock investments is never a wise idea, make sure you can handle the emotional consequences if you’re forced to sell.
Contract Expiration Options
Verify that you own at least 100 shares of each stock you’re considering, as each contract typically includes 100 shares. Decide on a contract expiration date. Although the duration is your choice, the Institute for Individual Investors recommends writing contracts that expire after 30 days with an option for you to renew. A renewable contract not only provides you with regular monthly income, but it also reduces your risks.
Set a Strike Price
Conduct market research or get professional advice, as setting the right strike price can be tricky. The strike price is the price per share the buyer will pay when exercising a right-to-buy option. While you want to set a price that will attract investors, the goal is make sure the investor does not exercise the option. For example, if you set a strike price of $25 per share and during the month the price never rises above $24, the buyer has no incentive to purchase the stock. Even if the price rises slightly above the strike, the buyer still may not exercise the option if not enough profit remains after subtracting his option premium.
Set the Option Premium
Research option premiums for currently listed covered calls or check with your broker before deciding on the price per share you’ll charge for renting 100 shares of your stock. Just as with setting a strike price, you can set an option premium in any amount you choose. In general, however, the closer the strike price is to the current trading price, the higher price you can set as an option premium. Prices ranging from 30 cents to $2.50 per share -- or higher -- are common.
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