I’m reading the book Multiple Steams of Income, and although I’ve dabbled in options before, it gave me the idea to get more active with options, especially in my IRA. With an IRA, you have more flexibility with your investment options compared to a 401k. You generally have a limited menu of mutual funds to choose from in a 401k, but you have more freedom to select your own investments in an IRA and can own individual stocks unlike most 401k’s.
An option is a contract for the right buy or sell a security at a given price in the future. There are two types of options: calls and puts. A call is a right to buy a stock at a certain price in the future. A put is the right to sell a stock at a certain price in the future. I’m going to focus on a covered call in today’s article. A covered call is when you own a specific stock and are selling someone the right to purchase that stock in the future for a certain price.
Let’s use Disney (NYSE: $DIS) for example. You purchased 100 shares of Disney at $60.00 and it’s currently trading at $63.50. One option contract is equal to 100 shares. Since you own 100 shares of Disney, you can sell one covered call and collect a premium from the purchase of the option. In other words, you can sell someone the right to purchase your 100 shares of Disney stock in the future at a specific price.
Today is July 7th and options expire on the 3rd Friday of every month. In order to get a higher premium, we’ll look at the August options chain since you’ll collect a bigger premium by looking at least 30 days out in advance. Disney is trading at $63.50 right now and you already have a gain, so let’s say you’re content selling the stock at $65.00. By looking at the options chain, you can look up $65 and you’ll see the corresponding option price is $1.48. You can sell someone the right to purchase your 100 shares of Disney at $65.00 per share on August 23, 2013. In return, you’ll collect a total $148 ($1.48 per share), which is the premium you earned for selling the option to someone.
If Disney is trading below $65.00 on August 23, 2013, you’ll get to keep your 100 shares of Disney plus the $148 premium. If Disney is trading above $65.00 on August 23, 2013, you’ll be forced to sell your shares of Disney at $65.00 regardless of what the stock is trading at. If Disney shoots up past $66.50 by August 23, 2013, the person who bought the option from you has profited.
This could be a great way to build up extra income within your IRA, especially since options expire without hitting the strike price 80% of the time. Since your IRA account is also tax-deferred, you won’t have to deal with the tax hassles either of buying and selling options. Feel free to comment below if you have any questions.