Use Options to Generate Income

by Dawn Pennington | May 24, 2011 9:06 am

Use Options to Generate Income

Let’s say you’re one of those careful money managers who cuts expenses, invests in some good stocks, and plans carefully for retirement. But have you saved enough?

If you’re one of the 47% of boomers worried about having sufficient funds and access to health care post-retirement — or one of the 42 million “junior boomers” who still have a good 20 years left to build wealth – there’s good news. There is an easier, simpler way to boost your income now so you don’t have to be one of the “working retired” who postpone their goals for another few years.

Options trading[1] investors know that buying call and put options is a terrific way to cost-efficiently use market volatility to generate big returns. But option buying isn’t the only — or even best — way to pad your portfolio.

Almost 80% of stocks trade in a tight range most of the time, eroding your option premium until they expire without any value. Indeed, about 80% of all options expire worthless or unexercised every year.

But buyers can’t buy an option without a seller. So if you’ve been a long time buyer who hasn’t profited, there must be sellers profiting from your losing trades. It’s time to reverse your fortune … literally. When you move to the other side of the trade, you put those odds squarely back in your favor. And you can conduct these trades every month.

Collect Consistent Premium with Covered Calls

You need look no further for income opportunities than your current portfolio. Selling calls against long stocks is the most widely used option strategy, by professional traders and novice investors alike.

If you have a stock that’s underperforming but you can’t bear to let go of it, selling calls against it every month until it kicks back into gear is an excellent way to get paid for your patience. Many covered call sellers end up owning their stocks for a deep discount because they collect premium for months or even years at a time.

Find more option analysis and trading ideas at Options Trading Strategies[2].

The strategy works best with front-month, at-the-money options. If your stock is currently at $40, then sell the $40 call with the nearest expiration date. If expiration is just around the corner, you can opt for the next month (or week, if you’re trading weekly options) out. If the stock drops, your losses are offset by the call premium. It’s not a full hedge, but it beats taking a bigger loss without any compensation for your trouble.

But if the stock moves up by more than the premium you collected, you may want to buy back the calls and sell calls at the next-higher strike price. Or, you can let the stock run and enjoy the capital appreciation without the option capping your upside. That’s what you wanted all along, for the stock to go up. That’s an option strategy you may be happy to “lose”!

Pad Your Portfolio with Put-Writes

Selling puts achieves a similar goal as the covered call, but eliminates the need to own the underlying shares.

The motive is the same — picking stocks that you believe are going to ultimately go up. The short put works on both stoic stocks as well as those that are a little more volatile, but still trading in a defined range. Ask your broker whether your account allows for the selling of “naked” puts. Some brokers restrict this strategy because of the risk involved.

Like the covered call, you want to sell the at-the-money options with the nearest expiration date. You do this so that you can capitalize again and again on premium collection. Sure, you could short an option with a further-out expiration date (to collect a higher amount of premium), but bear in mind that a lot can happen between now and that date.

It’s best to pick the closest expiration date possible and bank income more regularly. Wouldn’t you rather pocket 60 cents a dozen times over the course of the year than collect $5 now for an option that expires in 12 months?

If the stock rises significantly, the put buyer will “put” their shares to you at the strike price, which will be less than the market price. But what’s wrong with owning a stock at a discount … a stock that’s going up?

Which Strategy is Right for You?

Take a look at the stocks in your portfolio, as well as names you wouldn’t mind owning, and assess their performance. If you own the stock and it’s been stuck in a trading range for a while, the covered call is your better bet. If you don’t own the stock, selling the put is the more-sensible (and less-capital-intensive) strategy.

Both positions have the same profit and loss potential. When you sell options, the most you can collect is the amount of premium you receive at the outset of the trade.

During the life of the trade, you are looking for the underlying shares to remain in a tight range. The stock can lie flat, or even move up or down a bit, and you can still be a winner on expiration day. But keep in mind that these are bullish strategies; if the shares drop significantly, they aren’t best-equipped to provide you with income.

Adjusting Your Positions Mid-Trade

In the covered call strategy, if shares rise beyond the strike price, the buyer of the long call will “call” your shares away from you at the option strike (which would be above the market price, in an assignment situation).

If you’ve sold a put, the put buyer will “put” shares to you at the strike. Your loss in the trade will be the difference between the market and strike prices, which the premium you collected may not completely offset.

Remember, though, that these are stocks you like and wouldn’t mind owning … or buying again.

Endnotes:
  1. Options trading: http://investorplace.com/options-trading/
  2. Options Trading Strategies: http://investorplace.com/category/options-trading/trading-strategies/

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