A fixed rental income is something that still lures people to invest in real estate. And why not, who doesn’t want to earn 1-2% every month on top of the asset appreciation.
The same concept is applicable in the stock market too, you can potentially “rent” the stocks you hold for a fixed income month on month.
This is possible through a covered call options strategy.
In this article, we are going to compare Rental Income vs Covered Call Strategy and after reading this you’ll be able to pick one among th two for your investment goals.
The idea behind the covered call is simple. You buy a stock at price “X”, and then you sign an agreement (called call option) to sell the stock price “Y” after a month in exchange for a token amount.
The token amount would be rent in this case, and as long as the stock price remains in between X and Y, you’ll receive a regular rental income.
Below is an infographic that compares Rental income and Covered Call, and in all aspects covered call looks better
Illustration of Covered Call Option Strategy
Now let’s understand covered call strategy in detail.
In order to execute a covered call strategy, the first thing you need to do is obviously buy the stocks. Let’s say you buy 300 quantities of Stock “X” for $30000 and the current market price of the stock is $100.
And then you sell the call option of the same stock at strike price 110 for $3. If the lot size is 100, then you’ll need to buy 3 lots. The total premium you receive from this transaction would be 300*3 = 900$.
If the expiry period of the call option is 1 month, then by selling the call option you are giving the rights to the buyer to buy your stocks at $110 (strike price), however, the buyer is not obligated to do so.
There can be 4 outcomes to this trade at the end of the month (considering the option is not exercised)
Outcome 1: The stock price remains the same
In this case, you’ll get to keep the $900 that you received by selling options. That’s the net profit you’ll make
Outcome 2: The stock price increases to $110
In this case, you’ll get to keep the $900 that you received by selling options. Also, you’ll make $10*300 = $3000 profit on your stock holding.
Outcome 3: The stock price increases to $120
In this case, your option premium would increase from $3 to $10, so your loss would be $7*300=$2100. And you’ll make $20*300 = $6000 profit on your stock holding.
Outcome 4: The stock price drops to $90
In this case, you’ll get to keep the $900 that you received by selling options. And you’ll lose $10*300 = $3000 on your stock holding.
Based on the above 4 outcomes, you can notice that the covered call strategy reduces the max profit potential, but it also caps the max loss. 3 out of 4 outcomes are favorable to you.
The strategy is extremely useful when you are neutral or mildly bullish on the stock. The strike price selection for selling calls would depend on how much upside move you see in the stock till the expiry date.
Repeat the same process every month and in most cases, you’ll be able to earn fixed monthly income through this strategy that would be equal to your option premium.
Obviously, there are downside risks, as no investment is risk-free in this world. Even real estate can attract risks due to natural calamities, government regulations, or other unprecedented factors!
Learn more about the covered call option strategy at this link.
Based on the above comparison of Rental Income vs Covered Call Strategy, clearly covered call is a better fit. A highly liquid and predictable instrument is always better than an immovable, illiquid, and unpredictable instrument.