Most people would love to have some extra monthly income.  For those who have stocks or exchange traded funds (ETFs) sitting in a portfolio, selling covered calls can be a good source of additional income.

First, let’s break down the component terms. A call is a type of option contract that gives the purchaser the right to buy a stock or ETF from the seller at a set price for a specific period of time. In exchange for that right of locking in a price (called the strike price), the buyer gives the seller some money known as a premium. No matter what ultimately happens that premium is the seller’s to keep. The term covered means that the seller already owns the stock and is covered if the stock gets called away by the buyer. This is opposed to naked which means that the seller does not own the stock and would have to purchase it on the open market in order to deliver it to the call buyer.

Here I share my favorite option education sites so that you can learn more about options and covered calls.

Say you own 500 shares of Microsoft (MSFT) which is currently trading at 21.83.  Each call contract by convention typically covers 100 shares of the underlying stock or ETF.  So you could sell 5 June call contracts with a strike price of 22 for 0.45.  What this means is that you have given the purchaser of the call the right to buy your 500 MSFT shares at $22 per share any time between now and the third Saturday of June (option contracts expire on the third Saturday of the month).  In exchange for that right, the purchaser has paid you $0.45 per share which is yours to keep no matter what happens.  Your return on your MSFT shares is then $225 (0.45*500)/$10,915 (21.83*500) which equals about 2%.  Do this successfully for 12 months and you have a 24% annual return on stock that would otherwise be sitting.

If the stock is trading above 22, it will likely get called away.  You will then have to decide whether or not you still like MSFT and want to buy it back or use the proceeds to purchase another stock or sell puts against the proceeds.  If MSFT is below 22 at the time of option expiration, you will keep the premium and the stock.  Another covered call can be written for the month of July to bring in additional monthly premium creating a potential income stream.

Not all stocks and ETFs have options associated with them, but if they do, selling covered calls on them routinely can be a great source of additional monthly income for an otherwise static investment portfolio.