Stocks, which have been bought/owned, can be rented out much like how a real estate property can be rented out. This can be done through the Options Trading, named Covered Call.
What is a Call Option?
A call option is a contract which gives the call buyer the right to buy (or call) the stock from you at a certain Strike Price. This is a right but not an obligation and it can be effected any time before the call expiry date.
An example of Call Option with the underlying stocks of Microsoft (MSFT) is MSFT Jan13 27 Call. This is a Call Option on Microsoft Stock which expires on the 3rd Friday of January 2013 with the strike price of $27.
How to use Call Option?
The first step to perform a call option is to have ownership of the underlying stock. So, we need to start with buying the stock. The lot size of option is 100 units. In order to sell 1 unit of MSFT option, we would need to own 100 unit of MSFT stock. With the earlier example, we would need to invest in 100 unit of MSFT. Considering the price of MSFT on 1st Dec '12 ($26.62), we need to fork up $2,662.
The next step is to rent out the stock. Suppose we want to rent out our ownership of the MSFT share until the 3rd Friday of Jan (Jan 18th, 2013) with the strike price of $27. Checking out option chain for MSFT, we will obtain this: MSFT Jan13 27 Call with the price of $0.64. We start the covered call trade by Selling To Open MSFT Jan13 27 Call for $0.64. For this trade, we will earn $64
What happens on 19th Jan 2013?
On the Saturday right after the options expiry date, two things could happen depending on the price of the underlying stock.
- If MSFT falls below $27, the call option will expire worthless.We would not need to do anything for the previous call option and keep the $64. We can start to initiate another call option and earn another round of passive income.
- If MSFT is at or above $27, the call option might be exercised. When this happens, we will have to let go of the share at $27. Our gain would be $27 + $0.64 - $26.62 = $1.02. This is equivalent to a return of 3.83% (48 days) or a normalized return of 29.1% per annum.
I know you have a counter-argument that we will have paper loss if the underlying stock is below the strike price (Case #1). This will happen irregardless if we trade the call option. So, why not earn some return to cover potential paper loss on the downside? And still have a great upside return?
Another point to note is that our maximum upside is limited to our strike price. The strike price should be our target selling price. This is something we should be disciplined with anyway. Buy low and sell high at our target strike price.
If you would like to learn more about options trading, I would recommend reading the following books:
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