Options trading offers a range of strategies for investors, and one of the most popular uses of options is for income generation. For investors seeking steady returns, covered calls and cash-secured puts are two strategies that can generate income from options while managing risk. In this post, we’ll explore how each of these strategies works and why they might be a valuable addition to a well-rounded portfolio.
Covered Calls – Earning Income from Stocks You Own A covered call strategy involves selling a call option on a stock you already own. By selling this option, you’re giving someone else the right to buy your shares at a specified price (known as the strike price) before a specific date. In return, you receive a premium from the buyer. This premium can serve as an additional income stream on top of any dividends or capital gains from the stock itself.
Choose a Strike Price : The strike price you choose should align with your market outlook. If you believe the stock will not exceed the strike price before expiration, selling the covered call allows you to generate income without risking the loss of your shares.
Receive Premium Income : By selling the call, you earn the option premium, which you keep regardless of whether the option is exercised.
Manage the Risk of Assignment : If the stock price rises above the strike price, you may be “called away,” meaning you’ll have to sell the shares at the agreed price. This can limit your upside potential, but you still keep the premium.
When to Use Covered Calls
You’re neutral to moderately bullish on the stock and believe it will stay below the strike price. You own a stock long-term and want to generate extra income without necessarily selling it. You’re comfortable with the possibility of having to sell the stock if it reaches the strike price. Cash-Secured Puts – Getting Paid to Wait Another income-generating strategy is the cash-secured put. This involves selling a put option on a stock you’re interested in buying, with cash set aside to purchase the shares if the price falls to the strike price. By selling the put, you collect a premium, which effectively lowers your purchase price if you end up buying the stock.
Set a Target Price : The strike price of the put should be a price at which you’d be comfortable buying the stock. If the stock drops to this level, you’ll be assigned and required to purchase the shares.
Collect Premium Income : Similar to covered calls, you receive a premium upfront when you sell the put. This premium provides income and reduces your effective cost basis if the stock is assigned to you.
Hold Cash as Collateral : To ensure you can buy the stock if necessary, you’ll keep enough cash in your account to cover the potential purchase. This is what makes the put “cash-secured.”
When to Use Cash-Secured Puts
You’re neutral to moderately bearish on a stock you’d like to own at a lower price. You want to generate income while waiting for an ideal entry point. You’re willing to buy the stock if it falls to the strike price, effectively lowering your cost basis. Benefits of Income Strategies with Options Both covered calls and cash-secured puts offer a way to earn income from options with a controlled level of risk. Here’s why these strategies are popular with income-focused investors.
Additional Income Stream : The premiums earned from these strategies can enhance returns and provide steady cash flow.
Risk Management : Since these strategies are applied to stocks you’re willing to buy or sell, they help manage downside risk while still offering income.
Flexibility in Different Market Conditions : Covered calls are effective in flat to slightly bullish markets, while cash-secured puts work well in flat to slightly bearish conditions, allowing investors to adjust based on their outlook.
