The next sentence will look like those scams : “If you want extra money – monthly, passive income – with very little effort, then this is for you“. But it’s not scam, it’s legal stock-market-related trade for public (means everybody can do it ). If you have stock / share investment, you should have this monthly income already, if you have not – keep reading.

How big is the money? It’s not spectacular, but typically it will be around 2% to 4% monthly [1. the result may vary depends on the market but this is the typical result] – or more than 24% annually (can your saving produce this? maybe not)

Before we continue, we you are really new about ‘option’, please read this quick introduction about option.

The Mechanics

Profit Loss Chart for Covered Call

This is how it works:

1. You buy stock of a company from share market (the minimum quantity could be different each country, for example, in US the minimum is 100, but in Australia the minimum is 1000 – some companies have weird number for example 1014, but this number can be easily found)
2. You sell [2. the more correct term is to 'write' rather than sell, to avoid confusion with simply buying and selling option] option contract and back it by that particular stock. The option that you write is call option, in particular option that will expire next month. The proceed of this sale is your income. It’s upfront cash as your income and practically you don’t need to do much until next month.
   The strike price of this option should be higher than the current price (This is call ‘out of the money’ option. As you know, if someone buy a call option, that someone will have the right to buy on that strike price. You are the one who sell that stock for the buyer.

From the Profit Loss Chart above (read this PLC article if you are not familiar with it) you can see the characteristic of this strategy. When we start, we already in profit. Then you will have maximum profit if the price move up a bit, but the profit will not go up beyond your strike price.

For example:

1. You buy 1000 stock of a company that trade at $10 for $10,000.
2. Then you write a call option with strike price of $10.5 for next month with premium 30c each, so with 1 contract of option require 1000 share, you will get 1000 x 30c = $300. This is your monthly income.
3. After a month, at the expiry of the option, 3 things can be happening:

• The price go up above your strike price (above $10.5): say the price go up to $11. Then the buyer of your option will exercise the option (he/she can buy for $10.5 although the price is $11 now – that’s the reason they buy the option at the first place).But because of this, you actually have additional profit (buy $10, sell $10.5 ==> additional 50c x $1000 = $500 for your pocket – that’s why the strike price should be higher than the price when you write the option / out the money call.Then you simply repeat the whole process from the start again for next month option.
• The price go down below $10: the buyer will not exercise the option (why they want to buy at $10.5 when they can buy cheaper i.e: below $10 directly from the market), the option expired worthless and the value of your option is decreasing. Say the price goes to $9 then now the value of yout stock is only $9000.But this loss is only on paper because you don’t need to sell the stock (if you sell the stock then you make the loss a reality), what you do just write another call option for next month.Remember, if you don’t do this strategy and just hold the stock, if the price go won, you will have the exact on paper loss (losing value of the stock). By using this strategy actually because you have pocketed $300 in advance (from the premium), you may considered that that $1000 loss (price go down from $10 to $9) is offset by that premium. So, if you sell the stock (realized your loss) now, without this strategy you loss $1000, but by using this strategy you loss is partially covered and total loss will only be $700. ($1000 – $300) – Again you don’t need to sell as you can just write another call option.
• The price stay around $10 to $10.5: nothing will happen. You have pocketed your premium upfront and you will simply just do it again for the next month.

As you can see on above example, with $10000 you can derived $300 monthly (3%), if you want some more just multiply your capital, i.e: with $100,000 you can expect $3,000 monthly, and so on.

The Money

So, there are 3 different ways you have some profit from this strategy:

1. The monthly premium from writing call option (around 2-4% per month of your capital)
2. Dividend (you still received the dividend if the company distribute one, just like the rest of other stock holder)
3. Capital Gain (from the increase in price of the stock)

The Disadvantage

There are some factor that you need to know before using this strategy:

1. The Capital gain is capped at the strike price. For example, if the price on example above shoout to $12 from $10 (increase by $2), you only have 50c (from $10 to your strike price $10.5) profit. Still profitable but in this case you better off without this strategy.
2. You still need to have 100% capital to buy the stock. (You may reduce this by using margin lending, though)

Better Execution / Alternative

There are some better execution to improve this strategy:

• Use margin lending to leverage your position
• If you want to protect against downturn, you also can buy put option as protection. Although your monthly profit can be easily halved if you choose to have insurance/protection using put option.

Others

• Technically, this Covered Call strategy is ‘non-directional’ meaning no matte the market go up , down or sideways, you still received the premium upfront. But I will be more comfortable calling it “almost non-directional” because the fact that if the market go down, we still need to carry the risk that the stock can be sold lower than the buying price (making loss). But again that loss is on paper, so if you just continue to do it for the next month, then the loss will never be realized.
• Why called “Share Renting”? The fact that the writer of the option have monthly income without have to sell the stock and can keep doing it month after month, this can be explained much easier if we make analogy from property market about renting.  ‘Renting’ the share implied that the share is still ours (unless the option is exercised) and whoever rent it have to pay the rent (i.e: premium) to use it for a month.

As usual, if you have question or something to clarify, feel free to ask your question on the comment box below!

• As the term reveals, it started with buying some share in the share market. Say we buy 1000 shares of XYZ company for $10 each.
• At the same time, we will buy a put option at strike price $10 as protective put
• Then we hold those share until we reach the target.
• In the mean time, we can really ‘lock in’ our profit by ‘roll up’ the protective put (buying higher strike price put option as the price go up) or ‘roll down’ the protective put (selling the current put and buying lower strike price put).

To really understand how this work you need to understand how option works. Perhaps this article “How Option Produces Profit for Trader” may help. In a nutshell, when the price go down, the put option increase its value offseting the lost value of the stock.

The money

Using this “Protected BHP strategy”, investor make the money from 2 ways:

• Dividend income: only if the company distribute dividend
• Capital gain: when we sell the share and the share has gone up in value (the price has increased)

The disadvantage

There are 2 disadvantages with this strategy:

1. The protective put have a cost. It roughly should average around 1% per month. So, after 3 months, the stock need to go up above 3% before making profit. On the other word, put option for protection make the break even higher.
2. If the stock does not move at all, exactly at the same price when the option expired, you need to bear the cost of put option as a cost (your stock/capital is still protected but this cost will be incurred). Typically it will be around 3% – 5%. This is what I call “insurance cost”.
   As comparison, let’s talk about your car insurance. You pay insurance premium annually, if after one year nothing happen at your car, will the insurance company give back your premium ? OF course not… you actually will pay them another year of premium… This is exactly what happen here. The put option is your insurance, if it’s expired you need to pay another insurance.

But the advantage have much higher value than these tiny disadvantages: the stock is protected for any downturn so your capital will be 100% protected.

Better execution/alternative

Is there any better alternative? In fact , yes there is. Remember that you still need to bear the cost of put option whether the market will go up or down? How about like this: if the market go up: you make a profit less put option cost. If the market go down: your capital is protected (no loss) but also you got back the cost of your put option. I think this is almost what so called ‘perfect investment’ – it will require a little bit more calculation but it’s still simple.

To find out more: goto “Near Perfect Share Trading: NPST”

To see what happen if there is no protection on your share trading go to “BHP: the classic share trading strategy“.

• As the term reveals, it started with buying some share in the share market. Say we buy 1000 shares of XYZ company for $10 each.
• Then we hold those share for long term: say 1 year, 5 years, 10 years or even more
• In the mean time we don’t do anything except ‘Pray’ (probably not even praying) and hope that the value of the share is going up. Say if after 5 years, the price become $20, then we make 100% of profit.

The money

Using this “BHP strategy”, investor make the money from 2 ways:

• Dividend income: only if the company distribute dividend
• Capital gain: when we sell the share and the share has gone up in value (the price has increased)

The problems

There are 2 big problems with this strategy:

1. What if the price go down ?
   You might argue, this is the risk that we want to accept…. OK, fine if you would. But what if there is a way to ‘insure’ your share…. That’s is: if the price go down, you’re guaranteed to still at least get your money back.
2. How to ‘lock in’ profit ?
   We see it often: the price of a share can be rallying to record high only to drop below buying price after sometimes. Is there any way when we fell like it, we can ‘lock in’ the profit, so we are guaranteed a profit even the price drop, but we don’t need to sell the share ? The answer is a bold Yes.

Better execution/alternative

So, if we can eliminate 2 problem above, would it make share trading far more attrractive? Imagine you buy share, got the dividend and the capital growth, but if the price go down you’re protected… and even more, once the price reach the high value, you can lock in the profit on that price. This is what smart investor does!

To find out more: read ‘Protected BHP: the classic with protection’