When you buy a stock, you are of course hoping that the price will increase so that you can sell it in the future at a higher price.

If the stock pays a dividend, you can also reinvest the dividend into that same stock or something else. Thus, the dividend income can also be used to generate additional return. But if you could also just spend it, if you don’t want to reinvest it.

There is also another easy way to generate additional income using a stock you already own, and that is to sell calls against it—a strategy called a covered call. Additionally, you can also sell puts against the same stock to collect additional premium—the cash you get for selling an option.

Write Options to Squeeze Out More Income

Since each option contract represents 100 shares of the underlying stock, to be fully covered you will need at least 100 shares of the stock for each call contract sold. So if you sell two calls, you will need to have at least 200 shares of that stock to be fully covered.

If the stock price ends up lower than the strike price at expiration, the option will expire worthless and you will be free to sell another call if you want.

Before expiration, if you don’t want to risk losing the stock, you can also close the position by buying the same call. Or, if you don’t mind losing the stock at the strike price, just let your shares be called away at expiration. You can always buy back the stock at a later time.

If you sell a put, the option will expire worthless if the stock ends up at a price higher than the strike price. Just like in the case of the call, you can also buy to close the short put position prior to expiration or just let the stock be put to you.

Let’s use a real-world example to illustrate how this would work.

Example With Jumia

Let’s say you recently bought 500 shares of Jumia (NYSE: JMIA), the so-called “Amazon of Africa.” The stock once reached higher than $60 in early 2021 but today it is under $5 a share.

You think the stock could be at least a $10 stock again so you don’t want to sell, but then you also don’t know when and if that will happen. Let’s further assume that if the stock reached $7 in the next six months you would be happy to sell your shares. And if the stock dropped to $4 you would buy a bit more.

In such a scenario, you could sell five contracts of the May 2023 $7 call for $0.46 and two May 2023 $4 puts for $0.77 (these are actual closing prices on November 18).

From these two trades you collect a total of $384—$230 for the call and $154 for the put (I am ignoring the negligible commission which shouldn’t be more than a few dollars if you use a discount broker).

That total may sound low to you. But remember, in our example we are using a small position. The market value of 500 shares of JMIA is only $2,235! If you have a large enough position in a stock, you can certainly get thousands of dollars in premium per trade.

If we think of the premium like a dividend, then you are getting $230 against the $2,235 position for capping your stock’s upside at $7 for six months. That’s a yield of 20.6%!

On the put side of the trade, the broker will lock up $800 of your cash as a put reserve requirement for as long as the short position is open, so that’s analogous to collecting $154 for “depositing” $800 in a savings account for six months. The yield in this case is 38.5%.

The Other Side of the Coin

Ideally, between now and expiration, JMIA will increase in price but stop short of $7. This way, both the call and the put will expire worthless and you enjoy the gain in the value of your position. But if JMIA either rallies a lot or falls a lot, you could end up losing money either by having to sell at below-market price or buy at above-market price. The more above $7 or below $4 JMIA goes, the more you could lose.

Despite the risk for loss, used properly, this strategy can generate significant extra income for your portfolio.

To reduce buyer’s or seller’s remorse, it’s best to pick strike prices at which you would have sold (for the call) or bought (for the put) the stock anyway. Thus, it helps to use this strategy on a stock you know well. You could close either or both legs of the trade at any time before expiration to cut your losses if necessary. You also don’t have to sell the maximum number of calls. In our example, you could have sold just three contracts. This way, you leave 200 shares free with no upside limit in case the stock takes off.

Editor’s Note: As Scott Chan just explained, options are powerful and flexible tools. They can be used by stock investors to reduce risk and enhance returns. However, they’ve gotten a bad rap because they’ve been used improperly by “get rich quick” traders rather than long-term investors.

As with any tool, options can be abused. But the problem is not with the options tool itself, but in its application.

Which brings me to my colleague, the renowned options trader Jim Fink.

Jim Fink is chief investment strategist of Options for Income, Velocity Trader, and Jim Fink’s Inner Circle. Jim’s investment methods have enabled him to take his life’s savings of $50,000, turn the amount into $5 million, and retire early at age 37.

Jim has been sharing his trading secrets for over a decade, giving regular investors not just one, but two different opportunities to get paid every single week. In fact, while the market tanked several times over the last few years, he hasn’t closed out a single losing trade.

To learn more about Jim Fink’s money-making methods, click here.