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A Way to Generate Income With Options

Even though the stock market has had a wild ride so far in 2018, the S&P 500 has been about flat for the year. This means that most investors probably haven’t seen much gain in their stock portfolios. But investors who know how to use this simple technique would have added some extra income, even as the market goes through its ups and downs. The beauty of it is that they can do it again several times throughout year and make some extra income even if the stock market ends up going nowhere.

Here’s how you do it.

Some investors may think of options as high-risk, high-reward trading instruments that could make or lose a lot of money for you in a short amount of time. It is certainly true that trading an option can be very risky. But there is one option trading strategy that even beginners could use to generate income for your portfolio with limited risk. And that’s writing a covered call.

A call option is an option that gives the buyer the right, but not the obligation, to buy 100 shares of a stock, per option contract, at a specified price (the strike price) on or before the expiration date of the option. When you write a call option, you are selling the right, to a counter-party, to buy the stock from you at the strike price on or before the expiration date. The proceeds to the sale, called the premium, net of any applicable fees or commissions, is yours to keep whether the option is exercised or not.

Naked and Risky

When you sell a call without having the underlying stock, that’s called selling a naked call. This is a high-risk strategy because as the seller of a call, your potential downside outweighs the reward. Your maximum gain is the premium, and nothing else. On the other hand, the maximum loss is theoretically limitless since a stock could rise indefinitely. If the call option is exercised, you’ll need to buy the stock at the market price and sell it to the holder of the option at the strike price. (The broker normally would do this automatically for you.)

Your loss would be the difference in the market price and the strike price plus any broker fees and commission. Of course, before expiration you could buy back the same call option to close out your position, but you could still incur a sizeable loss if the market price for the option is well above your entry price.

A Lower-Risk Way

In contrast, if you sell a call against a stock you already own, that’s a covered call. You would need to have 100 shares of the stock for each option contract you sell to fully cover the position. Since you already own the stock, even if the option is exercised, you would not need to purchase the stock at the market price. You just sell what you already hold. This limits your potential loss.

Of course, if the stock’s market price happens to be well above the strike price, you would still lose out on the potential gain. In other words, when the option is exercised, you have to sell the stock at the strike price, but if you did not sell the option, you could have sold the stock at the higher market price.

Pick a Good Price

One way around this dilemma is to pick a strike price at which you would normally sell the stock anyway. For example, let’s say you own a stock which is trading at about $17, but you would be happy to sell it if it rose to $22 (a 29% gain) in roughly six months. In this case, you could sell an August call option with a strike price of $22. As of Friday morning, the August 17, 2018 $22 call option for the stock shown in the chart below could be sold for around $0.80, or $80 per contract sold.

If the stock falls just short of $22 at expiration, that’s the ideal scenario for you. The value of your stock gained and you didn’t have the stock called away. If the option expires worthless, you could sell another covered call to collect another premium. Rinse and repeat. Over time, this strategy can meaningfully boost your portfolio’s return.

Even if the option is exercised in August, you would pocket the gain of the stock from $17 to $22 plus the premium (not including broker commissions and fees). As long as the stock is trading at a level below the strike price plus the premium you received when the option is exercised, you come out ahead. (Again, the calculation does not include broker fees and commissions, which should be negligible nowadays if you use a discount broker.)

This strategy works best with stocks that have high implied volatility. In other words, option traders think the stock has the potential to make big swings so they are willing to pay a higher premium. It also works best with stocks you intend to hold for a while anyway.

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