Produce cash-flow with stocks: Selling Covered Calls

No investment vehicle fits everyone and a good investment vehicle needs to fit someone’s lifestyle, personality and philosophies. Most individuals believe stock investing is simply buying low and selling high. The sophisticated stock investor knows how to create cash flow and not just capital gains.

Cash flow is better than capital gains for 3 reasons:
1. Resilience from market swings and market chaos
2. Producing income stream on a regular basis
3. Taxation at a lower rate

Here are 2 ways how you can invest in stocks and create cash flow:
1. Dividends
2. Covered Calls

1. Dividends
Buy stocks that pay regular dividends and you are purchasing assets that add to your cash flow. Acquiring enough assets producing the income needed, you create enough to do whatever you like. If it produces even more than you need, then simply re-invest what you do not need and it produces even more wealth in the future.

2. Covered Calls
The covered call strategy is for the financially educated and more advanced investor.
A stock call option is a contract where the buyer has got the right but not the obligation to buy a certain stock at an agreed-upon price (strike price) until a certain date (expiration date). The seller of a call option has got the obligation to deliver (sell) the same stock at the strike latest by expiration. In return for his obligation, the seller of the call receives a premium as income from the buyer of the option. This premium is not just based on the movement of the stock price, but on the movement of time.

This is how covered call writing works:
You own stock ABC. You sell a call option of stock ABC after a predetermined amount of time at an agreed-upon price that you are willing to part with stock ABC under any circumstances (above the current market price). You receive the premium from the buyer of the call option. You either sell stock ABC at the agreed price or you retain ownership, if stock ABC does not move to or over the agreed price. You repeat until stock ABC is sold.

This is how you create cash flow from selling a covered call option:
This strategy is especially useful and working in difficult and volatile market conditions where buy-and-hold investors are suffering from huge up-and-down movements.
Towards the expiration date the stock could now go in 1 of 3 directions:
1. The stock went up and above the strike price. If the stock went up the buyer of the call will buy the stock at the strike price and as part of my obligation I would have to sell it to him. But I would have made money, a) on the difference between my purchase price of stock ABC and the strike price that should have been above my purchase price and b) on the premium paid to me because I am entitled to keep the full premium paid to me by the buyer of the call option.
2. If the stock went sideways and stayed below the strike price the option would expire worthless, and I would keep the premium paid to me buy the buyer of the call option. So, I did not make a capital gain by buying lower and selling higher but I would still have generated the premium income.
3. If the stock went down, the option would expire worthless and I would also keep the premium. Now, in this case, my stock would suffer a loss but due to the premium income this loss is either compensated or at least the premium income reduces my loss in stock value.

No matter what happens, you generate income from an asset you purchased. This is a very attractive way to generate a regular income. Even though the stock could be falling in value, if you continue to sell options on the stock month in and month out it brings money direct into your pocket. This income flows in even as you wait for the stock to bounce back in price. I keep the stock while the time decay is bringing in cash.

This shows, you can own stocks as an asset that generates a regular income and not only for capital appreciation. True cash-flow investing is when the underlying asset, in this case your stock, can go down but cash flow stays more or less consistent.

Sven Franssen