In the investment world, there exists mutual funds and ETFs for pretty much every investment strategy you can think of. There are even funds that use option trading as a selling point. Some examples are GATEX for mutual funds and QYLD for ETFs.

To be clear, such funds still hold mostly stocks and ETFs. The difference from normal equity-only funds is that they also sell options using strategies such as covered calls, short straddles, and short strangles. By doing this, these funds squeeze more income out of their existing positions.

Beware of Strategy Backfiring

The extra return is nice, of course, but there is also potential downside risk. Selling options usually works best when the underlying securities do not move a lot. And in the case of these funds that sell covered calls, they work best when the market is neutral or slightly bearish.

When you sell calls, for example, you don’t want the underlying stock to go up enough to be in the money, in which case the stock would be called away at the strike price. Since a call won’t be exercised unless the strike price is lower than the market price, when a stock is called away, you are effectively selling the stock at a below-market price. Or you have to close your short position at a loss.

Similarly, when you short a straddle or strangle, you want volatility to be low. Best case scenario is when both legs of the straddle or strangle expire worthless. The more in the money either the call or put becomes, the less profitable the trade becomes, and likely, the bigger the loss.

For those unfamiliar with what they are, a straddle is when you sell both a call and a put with the same strike price and expiration date against the same underlying stock. A strangle differs from a straddle in that in a strangle, the call and put would have the same expiration date but different strike prices.

In any case, when volatility is low, options are more likely to expire worthless and they can be shorted again and again, generating an extra income stream alongside of dividends. But when things go wrong and the shorted options move into the money, it can adversely affect a portfolio’s return.

Option Income Funds Underperformed

The chart below compares the performances of the two option income funds mentioned earlier against SPY, the S&P 500 ETF, proxy for the market. As you can see, over the past year, the two funds have significantly underperformed the S&P.

With the S&P 500 up a lot over that period, someone who invested in one of these funds would have been better off just going with a fund that’s purely long stocks. Notice that when the market was falling in September and October, the two funds closed the gap. As mentioned earlier, these funds tend to outperform when the market is neutral or slightly bearish.

However, that’s not to say the idea of selling options to generate more income is bad. In fact, used properly, the strategy can increase your return. For example, when the market is rallying, it’s best to avoid writing calls that are close to the money even if the premium for such options is higher.

Ideally, try to achieve a balance between collecting a good-sized premium for writing an option while still picking a strike price that’s unlikely to be in the money during the life of the option. One big losing trade can dramatically lower your overall profits. On the other hand, even if each trade doesn’t bring in a ton of cash, if trade after trade ends in a profit, overall you would be better off. Thus, if almost all the options you sell end up with option expiration, and you are able to limit losses on the trades that move against you, then selling options can be quite a profitable endeavor.

When you trade options, you will need to pay closer attention to your positions compared to vanilla stock investing. You will also want to learn at least the basics of options trading before starting. If you are interested in selling options for income, you are probably better off making the trades yourself rather than putting your money in a fund that does the trades for you. You will have more control and freedom. Happy trading.

Editor’s Note: Scott Chan just shed light on options trading, to show you that it doesn’t have to be a scary experience. But the above article only scratches the surface of our team’s expertise.

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. Click here to learn more.