Many investors rent out their stocks every month to generate potentially larger returns. Of course, when they do that, they don’t call it renting: The term they use is a “covered call.” That’s when you sell an option to another investor to buy your stock at an agreed-upon figure, called a strike price.
Why would you rent your stock? Let’s consider a hypothetical example: Maybe you bought 1,000 shares of a company some time ago for $18, and the stock has performed nicely, but now seems to be stuck in a range, hovering around its current price of $23. You don’t mind owning the stock. But it’s not doing much.
A bullish investor could pay $23,000 to buy the shares from you on the open market. Or he could buy 10 call options for $2 per share, or $2,000 total investment. Each call option gives the right but not the obligation to buy 100 shares of the stock by a certain date at a specific price. Only some stocks are optionable, via the Chicago Board of Options Exchange.
As Time Goes By
The value of those call options will generally rise and fall with the value of the stock. So if that stock hits $27, the investor can use the option and buy all the stock or can just sell the option without ever owning the stock. So if that investor bought October $25 calls for $2, they could now be worth $3.50 each, or $3,500. That’s a nice profit of $1,500 on a $2,000 investment. (This example excludes commissions and the difference between the bid and the ask price. And yes, the valuation of options is complicated.)
But remember, every day that passes toward the option’s expiration day means these options become worth a little less money. If that stock goes down, the options become worthless, and the total investment of $2,000 could be lost.
If the stock rises to the strike price of $25 or higher, you will probably be called, which means you have to sell your stock at $25, which is not terrible because you bought it for $18 — plus you received $2,000 for the option. If that stock does not make it to $25, then you keep the $2,000 and the stock.
You could sell the next month’s call option at $25 for maybe another $2,000 — or sell a call further into the future for more money. This could be a good strategy if you are long (meaning you already own it). But it might not be optimal. After all, if you bought the stock at $18 and think it’s heading toward $40, then it would not be advisable to sell it at $25.
Some Other Considerations
- Stocks that are more volatile have higher options pricing.
- You must be approved to trade covered calls by your broker. With experience, you can also be approved to deal in advanced option trades.
- A “covered call” means you have covered your option sell by actually owning the stock before you sold the call. Uncovered calls could be riskier.
- Selling a covered call is no more risky than owning the individual stock, so it is allowed inside of individual retirement accounts. Buying calls and put options (options bought when you are betting that a stock will go down in value) are riskier and are not allowed with retirement funds.
Never buy a stock just to sell the call. Make sure you like the stock on its own merits, because if you buy it to sell a call, and the stock tanks, you could still lose much of your investment, regardless of the extra you could make on renting it out.