Options for Increased Income
Covered Call Options
Selling covered call options is a tactic I use to increase the income coming into my account and to augment the income received from the dividends distributed by the companies themselves.
A call option is, at its core, simply an option contract. It's derivative in nature and it’s value exists in its contractual obligation between the buyer and the seller. For the call option buyer it's a contract which provides the buyer the right, but not the obligation, to buy at will a specified quantity of an identified security at a specified price, known as the strike price, within a fixed period of time, known as the expiration date. For the seller of a call option (sometimes referred to as the writer of the option), it represents an obligation to sell the underlying security at the strike price if the option is exercised. As a result of executing a call option contract, the call option seller generally receives a premium for taking on the risk associated with the obligation. For almost all stock option contracts a single contract covers 100 shares. For option contracts known as mini-options the contract covers 10 shares and these contracts are unique to several high priced securities like Apple, Amazon and Google.
Covered call writing is either the simultaneous purchase of stock and the sale of a call option, or the sale of a call option covered by underlying shares currently held by an investor. The key is that the call is written only when the call seller owns the underlying equity and therefore the call option is considered “covered”. The seller of the call option receives cash for selling the call but then immediately becomes obligated to sell the stock at the call's strike price if assigned, therefore limiting any upside potential in the stock price beyond the strike price if the underlying stock goes up in price. In other words, an investor is "paid" for agreeing to sell his holdings at the strike price. If the stock instead falls, there is a limited amount of price protection because the premium received from the call's sale reduces the seller’s base price.
A covered call option is best used when the investor would like to generate income off a long position while the market is moving sideways. An investor who buys or owns stock and writes call options in the equivalent amount can earn premium income without taking on additional risk. The premium received adds to the investor's bottom line regardless of outcome.
If assignment is not received because the stock price hasn’t attained the strike price, the call option will expire worthless. The seller’s resultant upside profit potential is any gain in share value that occurs prior to the expiration date plus the premium received from selling the call option contract. The downside loss potential, however, is substantial and comes entirely from owning the underlying shares. It is limited only by the stock declining to zero. The break-even point for the seller is the underlying stock price’s original purchase price minus the premium received.
This strategy is one of the most basic and widely used option strategies. It combines the flexibility of listed equity options with the benefits of stock ownership. Although this strategy may not be suitable for everyone, it can provide a stock-owning investor limited downside stock price protection in return for limited participation on the upside. More importantly the covered call sale generates income that can supplement any dividend income paid to eligible underlying stockholders.
Who Should Consider Writing Covered Calls?
- Any investor who wishes to generate income in addition to receiving any dividends from shares of underlying stock should consider writing covered calls.
- Any investor who is neutral to moderately bullish on a certain stock should consider writing covered calls on the positions they hold.
- Any investor willing to limit the upside profit potential on a specific stock in exchange for reducing the base cost of the shares owned.
How I Use Covered Calls
If I hold 100 shares of stock that has a corresponding set of options and the I have either a neutral or slightly bullish opinion on its price over a given period of time, I will sell a covered call option. I usually select an out-of-the-money call option that can be sold for a premium that provides at least some downside stock price protection. I also select a call option that fits my tolerance for risk and the time frame of my opinion. If I’m extremely bullish on the underlying stock, I may instead choose to leave the stock uncovered until it stabilizes at a higher price.
The Advantages and Risks of Selling Covered Calls
Selling covered call options offers the advantage of offsetting any downside risk and adding to the upside return, but it also means I trade current cash for any upside gains. There is also the advantage that the passage of time has a positive impact on this strategy, all other things being equal. It tends to reduce the time value (and therefore overall price) of the short call, which would make it less expensive to close out if desired. As expiration approaches, an option tends to converge on its intrinsic value, which for out-of-money calls is zero.
The risk is that the call option sell has to hold onto the shares as long as the option contract is in force. Therefore, if I want to sell my shares before option expiration, I’m required to buy back the option which may cost some or all of my calculated profits.
Cash Secured Puts
Selling cash secured puts is a tactic I use in order to bring income into my account other than my own hard earned cash. I also use this strategy to enter a position at a price below the currently quoted price and at a price more appropriate to the underlying value of the stock itself. Similar to call options, a put option is, at its core, simply an option contract. It's derivative in nature and it’s value exists in its contractual obligation between the buyer and the seller. It’s also considered a long position and is therefore related to buying (going long) stock.
The cash-secured put involves writing an at-the-money or out-of-the-money put option and simultaneously setting aside enough cash to buy the stock. The goal is to either be assigned and acquire the stock below today's market price or to collect the premium income for use in later trades.
When an investor is bullish on an underlying stock he can sell a cash secured put and hope for a temporary fall in the price of the stock. If it falls below the strike price, the put will most likely be assigned and the put would buy the stock at the strike price less the premium received.
What are the Risks?
One possible risk is that the stock may fall significantly below the strike price and the investor will be locked into a loss at assignment. Any investor in this situation must be comfortable prior to selling the put with being assigned the stock at the strike price.
Another possibility is that by waiting for a price dip for entry, the investor may miss out on a stock that continues to climb upward. Subsequent decisions would obviously repeating the short put strategy or closing out and buying the stock outright.
What kind of Investor Sells Cash Secured Puts?
This is primarily an income producing or a stock acquisition tactic for a price-sensitive investor. As a stock acquisition tactic, the goal is to collect the premium income and then acquire the underlying stock by assignment at a strike price less the premium received.
Unfortunately the assignment of stock is not guaranteed. If the stock’s price remains above the strike prior to the expiration of the option, the stock will never be purchased. The result would be pocketing the premium received for the put.
What is the Maximum Loss?
The maximum loss is limited but substantial. The worst that can happen is for the stock to become worthless. In that case, the investor would be obligated to buy stock at the strike price but the loss would be reduced by the premium received for selling the put. The maximum loss, however, is lower than it would have been had the investor simply purchased the stock outright.
What is the Maximum Gain?
The maximum gain from the put option itself is limited to the premium received at the time of sale. Gains in addition to the put option may include gains received after assignment when the stock appreciates in value. The best scenario would be for the stock to dip slightly below the strike price at the put option's expiration, trigger assignment and then rally immediately afterwards to record heights. The put assignment would have allowed our investor to buy the stock at the strike price minus the premium just in time to participate in the following rally.
What about Time Decay?
The passage of time will have a positive impact on this strategy, all other things being equal. As expiration approaches, the option tends to move toward its intrinsic value, which for out-of-money puts is zero. If the original forecast and goals still apply, the investor keeps the premium and is free to either buy the stock outright or write a new put.
