One of the primary reasons why people start selling covered calls is the monthly income that is constantly being generated. Approximately 75% of all option contracts that are held until maturity expire worthless. A savvy investor knows this and is always looking for a way to use this information to his or her advantage.

You can, in fact, sell a new call against your stock positions every month once the open call expires. As long as the buyer of the option contract does not exercise his right to buy your stock it is possible for you to generate a consistent stream of income that occurs each and every month.

What is a Covered Call

Before we begin discussing how to generate a monthly revenue source from our current stock positions let’s first discuss a few covered call basics. A call contract is a specific type of contract that gives the purchaser the right, but not the obligation, to buy a stock from the seller at a certain price as long as the purchaser does so on, or before, a certain date. In return for selling this option to buy to the purchaser the seller receives a specific amount of money known as the premium.

It is this premium that is so crucial to the covered call strategy. Regardless of what ultimately happens to the price of the underlying stock this premium is the seller’s money. We refer to this strategy as being ‘covered’ simply because the seller of the option already owns the underlying stock and can simply transfer it to the buyer should the call option be exercised before the expiration date.

If the seller did not actually own the underlying stock, he or she would be considered to have sold a ‘naked’ call which not only opens the seller up for unlimited liabilities but is also typically not allowed in most online brokerage platforms.

How Do Covered Calls Generate Monthly Income

To make this explanation a bit easier let’s take a look at a hypothetical two month example.

In this example, we have decided that we want to buy 100 shares of XYZ stock which is currently trading at $60 per share. Knowing what we now know, we have elected to sell a call option against this stock in order to generate a bit of extra money and to decrease our overall basis in this stock should the price slide a bit. On the same day that we buy the stock we sell a call that has a strike price of $65 for $2.

$200 is immediately deposited into our account for us to so with as we please. We can elect to purchase more stock with it, withdraw it and buy someone a gift, or we can simply leave it in the account for future use. Many retired individuals actually withdraw these funds to help supplement their retirement income.

During the first month, the value of the underlying stock decreases from $60 to $59. As such, the option expires worthless and we are free to either sell another call against our shares, sell the stock for $59 (which would result in an overall profit of $100), or we could just wait and see how the stock performs before doing anything at all. In this example, we have decided to sell another call contract against our shares for $1.50 (since the price of the underlying stock has decreased a bit so will our option premium IF we sell it at the same strike price).

Again, this premium income of $150 is immediately put into our account and is ours to keep.

XYZ company then reports better than expected earnings and the price of the stock jumps to $66. The buyer of our latest call will then exercise his right to buy our stock at $65. We will receive $6,500 (less commissions) from the sale of our stock and can reinvest these funds however we see fit.

So how did we do? Over the two months that we have owned the stock we have received $350 in premiums and had capital gains of $500. Our $850 gain represents a 13% increase in just under 2 months. If we would have used the traditional buy-and-hold strategy our $500 gain would represent just a 7.6% gain. While this rate of return is certainly nothing to sneeze at you would have almost doubled your return by selling covered calls.