How to Use Stock Market Options to Boost Your Income

While more Americans than ever are invested in the stock market, very few know about a little secret that allows them to generate more income without incurring any additional risk. Is this the "free lunch" we are all after? Well, yes and no -- so for those of you who are dissatisfied with your portfolio's return or for those who find the quarterly dividend check too paltry, you do have other options. In fact, your other option is options, and they are surprisingly simple and easy to use.

When most people hear the word "options" they cringe either out of the unfounded fear that options are too risky or that they are too complicated to learn how to use. I am here to tell you that both these stereotypes are wrong, and that there is no reason why anyone should be afraid to start harnessing the amazing potential of options . Options are versatile and have many uses, but for today's purposes we are going to focus on a single trading technique that involves "covered call options."

Don't worry if you've never heard the term before, because I will explain it in detail and also tell you how you can begin to take advantage of options to boost your income. First, this trading technique works best for those who already have an established portfolio of stocks and might be interested in generating additional income. However, even for those who currently do not own any stocks, this trading strategy might be useful when you decide to purchase a stock. But you must own a stock -- at least 100 shares of it -- before you can begin selling covered call options.

So what are call options, or covered call options as the case may be? A call option is the right to purchase a stock at a particular price at a specific date in the future. One call option gives the owner the right (not the obligation) to purchase 100 shares of stock. Two covered call options gives the owner the right (not the obligation) to purchase 200 shares of stock, and so on. Now, owning a call option can be very risky because it can expire worthless, but that doesn't concern us because we are not going to be owning, but selling, call options and generating immediate, risk free cash. The owner assumes all the risk, while the seller can sit comfortably on risk free income.

Let's proceed with a concrete example to show how simple and easy it is. Today (July 24, 2007) UPS (United Parcel) closed at $74.68. Suppose you owned at least 100 shares of the stock and were interested in generating some extra income. UPS does pay a nice dividend of $1.68 a share, which comes to about $42.00 every quarter, but why not use your 100 shares to generate even more income? Remember, options are versatile and flexible and allow traders to employ strategies most tailored to their individual financial concerns. Suppose you estimate that UPS has reached a temporary peak and will either decline or consolidate over the next few months, but instead of just watching your stock bleed profits, why not generate some cash by selling a covered call option? For instance you could sell one "covered" call option at the strike price of $75.00 per share with an expiration of September 21st and generate $235.00 in immediate income. That's better than your annual dividend payments and it's an option with an expiration of just about two months.

So what does this imply? If you do sell this option this means that you are obligated to sell 100 shares of UPS at $75.00 a share if the buyer chooses to exercise the option on Friday, September 21st. Whether or not the buyer chooses to exercise the option depends on the price of UPS. If by some occurrence UPS is selling for $82.00 on September 21st then the buyer will gladly take your 100 shares for a price of only $75.00. In this circumstance you clearly would've been better off not selling a covered call option, but notice that you didn't lose anything -- you still sold your stock at $75.00 a share and generated $235.00 in cash. You keep the cash regardless of the final outcome.

However, suppose on September 21st UPS is at $70.00 a share, then the option will expire worthless. You get to keep your 100 shares of UPS and the $235.00 you received from selling the "covered" call option. So while you lost "paper" gains on your stock, you were able to generate risk free cash. At this point you can just continue to hang on to the stock, or sell another covered call option -- perhaps one that expires in November -- and generate even more cash. By selling covered call options throughout the year you generate much more income than you do from your regular dividend payments.

But options always have plenty of options. For instance, say you think that UPS is going to continue to increase in price over the next few months, you can still sell covered call options to generate cash. Instead of choosing the strike price of $75.00 dollars, you can choose another strike price, say $80.00. For the options that expire on October 19 you can generate $70.00 in immediate income. While you do receive less income from choosing the higher strike price, it does allow a window for an extra $5.00 in capital gains. So in this case, if the stock is at $82.00 dollars on expiration, you liquidate the stock at $80.00 per share and you still keep the $70.00 you received from selling the call option. Conversely, if the stock is at or below $80.00 per share on expiration, then you keep the stock and the income you received from selling the call option.

If you want to know if options are actively traded on the stocks you own, or plan to own, then visit Yahoo Finance and select options. Here it will display the call and put options for your stock, the available strike prices, and the price of each option. My advice is to put in a limit order when you decide to sell a call option. Options are extremely volatile and price changes can be substantial -- a 2 or 3 percent change in the price of a stock can cause option prices to move by 20 to 30%, or even more. Option prices often go up significantly on days when the price of the stock is up, so it is best to sell options on those days, or just place a limit order for a set price.

Covered call options are safe, prudent instruments that allow investors to achieve above average returns with less risk. I encourage all investors to analyze their portfolio and see if selling covered call options will work for them.