Stock options come in two different flavors, but they can be combined into countless different strategies. Option income strategies are designed to take advantage of time decay to generate a consistent income. Investors may decide to use call options, put options, or a combination of options to achieve these goals.
In this article, we will look at option income strategies, how to decide between put and call options, and other considerations for investors to maximize their risk-adjusted returns.
Option Income Strategies
Most option income strategies are designed to take advantage of time decay – or the theta – by collecting premiums. For example, the most common income strategy is a covered call where an investor sells the rights to acquire shares they own in exchange for a premium. The call option becomes less valuable over time as the likelihood of the stock price exceeding the strike price is diminished. Eventually, the option expires and the premium becomes a profit.
Option income strategies can be divided into two categories:
- Credit Spreads – These are the most common strategies whereby a call or put is sold against an underlying asset or another call or put for a net credit. That is, the investor is taking more premium than they’re paying out. Examples: Covered calls, iron condors, or butterfly spreads.
- Debit Spreads – These are less common strategies whereby a call or put is bought while selling another call or put for a net debit. That is, the investor is taking in less premium than they’re paying out. Examples: Diagonal or calendar spreads.
Option income strategies enable investors to generate an income that may be less risky or more lucrative than simply buying dividend paying stocks. The risk is that the underlying asset will move in a way that leads an option to be exercised, which could result in a loss on the trade or the unwanted sale or purchase of an asset. Investors should take the time to fully understand options strategies before implementing them in their own portfolios.
Deciding Between Puts & Calls
Options can either be a right to buy (call) or a right to sell (put) with four possible trades, including buying calls, selling calls, buying puts, or selling puts. The combinations of these trades form the basis for all stock option strategies – even complex strategies involving multiple timeframes. There are many different factors involved in the decision between put and call options, but it primarily boils down to who receives the assets in the end.
Let’s consider two common and equivalent strategies:
Covered calls involve an investor selling a call option – or a right to buy stock – against an existing long stock position. For example, an investor may own 100 shares of Pear Inc. at $160.00 and sell one out-of-the-money call option with a one-month expiration and $165.00 strike price in exchange for a $1.60 premium. The investor receives an immediate $160 in premiums on their $16,000 position, generating a 1% monthly return.
The two possible outcomes for the trade are:
- The stock trades above $165.00 by expiration and the investor must either sell their 100 shares at $165.00 or buy back the option at a fair price.
- The stock trades below $165.00 by expiration and the investor keeps the $160 premium and their existing shares.
Income investing with puts involve an investor selling a put option – or a right to sell – without any underlying asset. If you have the funds to purchase the shares if assigned, this is called a covered or cash-secured put. For example, an investor may sell a put option on Pear Inc. currently trading at $160.00 with a strike price of $150.00 in exchange for a $0.80 premium. The investor receives an immediate $80 in premiums that they can book as a profit in exchange for the possibility of having to buy 100 shares Pear stock at $150.00 per share.
The two possible outcomes for the trade are:
- The stock trades above $150.00 by expiration and the investor keeps the $80 in premiums as a profit.
- The stock trades below $150.00 by expiration and the investor must purchase 100 shares of stock at $150.00. The investor still keeps the premium received for selling the put.
Most investors begin with covered calls since they provide monthly income with a relatively low risk, but that doesn’t mean that selling puts are a bad strategy.
The benefits of call options include:
- Call options may be the only possibility for retirement accounts or individuals that don’t qualify for higher options trading levels with their brokerage.
- Long-term investors might want to generate an income from their long stock positions or use them as an alternative to dividend-paying stocks.
- Investors may use covered calls as a way to sell a stock more profitably.
- Risk-averse investors might be looking for simple strategies.
The benefits of put options include:
- Put options might be more lucrative than covered calls since there’s no underlying stock to purchase and a long-term upward bias in the stock market.
- Investors looking to own a stock may want to use cash-secured puts to acquire stock more profitably rather than simply purchasing it outright.
Advanced & Neutral Strategies
The simple strategies mentioned above make use of either a put or a call option and make a directional bet on the market. But, many advanced options strategies rely on multiple options or even combinations of call and put options, while taking a neutral outlook on the market. In these cases, investors should consider the individual strategy and what types of options they’re comfortable using to accomplish their goals.
For example, the iron condor is built by selling one out-of-the-money put option, buying another out-of-the-money put option at a lower strike price, selling one out-of-the-money call option, and buying another out-of-the-money call option at a higher strike price. The maximum gain is the net credit spread received when entering the trade and is received when the price of the underlying asset stays between the strike prices of the short put and short call.
As you can imagine, these strategies can become very complex. We’ve found that “simple” strategies like selling calls and puts in combination with stock ownership and cash management generates the best results for our clients.
The Bottom Line
Stock options come in two different flavors that can be combined in countless ways. When deciding between put and call options, investors should consider the expected direction of price movement, their goals with the underlying asset, and their risk tolerance, among other things. The key is ensuring that they’ve designed a trade that accomplishes their goals while remaining within their risk tolerance.
The intent of this article is to help expand your financial education. Please seek the guidance of an investment professional before using stock options.