Before beginning our discussion on using options as part of an income producing strategy, we should first describe some very basic features about what an option is and is not.
To begin with options on common stocks are not securities like the stocks, bonds, mutual fund shares, or the ETFs you might have in your investment portfolio.
Stocks represent a fractional ownership share in the underlying company and a claim against that company’s future earning power and cash flow.
A bond is simply a debt instrument that spells out a company’s obligation to repay the money it has borrowed from the bondholder while specifying the interest rate it must pay to the bondholder on the money it has borrowed.
ETFs are simply a tradeable security that is a collection or basket of stocks, bonds or other securities.
Stocks, mutual funds, and ETFs have no expiration dates. Bonds have specific maturity dates when they have to be redeemed but they don’t expire.
Options are flexible contracts that can be used in a variety of ways. Institutions and professional traders primarily use them for hedging and risk management. Because of their flexibility, options can and are also used to generate income. Options do have specific expiration dates.
In this article, we focus on how individual investors can use selling options as an income-generating strategy.
There are 2 types of options: Calls and Puts. Call Options (that are sold) are called covered calls. They are covered because your broker will require that you as the option seller own the stock, in case the option buyer decides to exercise their right to buy the stock at the strike price. Put Options (that are sold) are called cash-secured puts. They are cash-secured because the broker will require that you as the option seller have enough cash in your account to buy the underlying shares, in case the option buyer decides to put (sell) the stock to you at the strike price. Let’s take a look at some concrete examples for both of these scenarios.
Consider Boeing (as an example), which paid a $2.05 quarterly dividend in 2020. With the stock around $124, investors could (in 2020) sell the May $145 Call for about $11.50 or the May $105 Put for $12.
Selling a call obligates the seller to sell the stock if the market price goes above the $145 strike price. The seller would make $1150 on the option sale and then would be required to sell 100 shares of stock at $145 for $14500. This may be desirable as long as the cost basis for Boeing was less than $14500.
Similarly, selling a put obligates the seller to buy 100 shares of stock for $10,500 if the market price goes below $105. The seller would then gain $1200 on the sale of the option. This may be desirable as long as the option seller doesn’t mind owning Boeing at $105 per share.
Assuming you have some idle cash sitting in your brokerage account, selling cash-secured put options is a way to use that cash to generate income. Likewise, assuming you have some stock that is already profitable if sold at the strike price, you can also generate extra cash on the covered call option sale.
Selling options is generally considered a low-risk strategy because the risk is well defined. Let’s look at selling the cash-secured put to see that there are only three possible outcomes.: 1) the option expires, and the seller keeps the option premium, 2) the option buyer exercises his/her right (not the obligation) to put the shares to the option seller, and the option seller must buy the shares at the strike price, and 3) the option seller can buy back the option to avoid having the shares put (sold) to them.
Similarly, selling the covered call has only 3 possible outcomes.: 1) the option expires, and the seller keeps the option premium, 2) the option buyer exercises their right (not the obligation) to buy the shares from the option seller, and the option seller must sell the shares at the strike price, and 3) the option seller can buy back the option to avoid having the shares sold (called away) by them.
In summary, Selling Options is a way to create income (by keeping the premium) when the option is sold, as opposed to corporate dividends that are paid only quarterly.
This article is for informational purposes only and should not be considered a solicitation to buy or sell any security. The securities or strategies mentioned herein may not be suitable for all types of investors. The information contained in this article does not constitute any advice, especially on the tax consequences of making any particular investment decision. Before acting on any information found in this article, readers should consider whether such an investment is suitable for their particular circumstances, perform their own due diligence, and if necessary, seek professional advice.
Really enjoy reading