Three Income Strategies Using Options

Some traders use options to gain leverage in an attempt to increase their returns, but that’s only one of many options strategies. There are a number of options strategies that attempt to control risk and generate income. Here are three examples.

1. Selling covered calls
The strategy: An investor will hold a long position in an underlying stock while selling (or writing) a call option on those shares in order to receive income.

Selling (or writing) covered calls has been used for years by investors and traders to earn extra income on stocks that they own. Jim Bittman, senior instructor at the Options Institute, the educational arm of the Chicago Board Options Exchange (CBOE), explains: “The covered call strategy is appropriate for income-oriented investors who also own stock. By selling the call, you hopefully get the benefits of extra income and some stock appreciation while slightly reducing the risk of stock ownership. Covered call writing is great in an IRA or other tax-deferred account where there are no immediate tax consequences for getting the stock called away.”

When you sell a covered call, you receive cash up front (premium). In an ideal situation, the stock price will go up, but not enough to put the option in the money. In that situation, the seller will get to keep the money from the sale of the options contract and the stock. If the price appreciates enough, the options contract seller will sell the stock for a profit, and keep the proceeds from the sale and the sale of the contract. If the price falls, the seller of the contract keeps the money from the sale of the option, but the stock that underlies the position will have lost money.

Some people who want extra income will seek out specific stocks just to sell calls (this transaction is called a buy-write). Underlying stocks that are neutral to slightly bullish are considered ideal for the covered call strategy.

Because you may keep the stock and also receive income, it’s not surprising that selling covered calls is so popular. Here’s a brief example of how it works: 

1. You buy 100 shares of ABC stock for $22 per share. Approximate cost: $2,200
2. The June 25 calls cost $1.75 per contract. You sell one call (the right to buy 100 shares) and receive $175 in premium. ($1.75 x 100 shares).
3. The cash is immediately credited to your trading account.
4. If the stock is higher than $25 a share (the strike price) at expiration, the stock will probably be called away from you (taken from your account and sold at $25). If the stock never reaches $25 a share, the option expires worthless on the Saturday following the third Friday in June. Either way, you keep the $175.
5. If you still own the stock, you can sell covered calls for the following (or any) month.
6. If you no longer own the stock, you are free to buy back the stock and sell covered calls for the following (or any) month.¹

Although this strategy seems almost too good to be true, there are risks. “In a rising market like the 1990s, it was hard to lose putting on a covered call position,” recalls Joe Harwood, manager of the options help desk at the Options Industry Council (OIC). “You bring in premium and sell the stock at a higher strike price than it’s trading for. Everyone’s happy until the market turns around. Once the stock has gone down more than the value of the call you sold, you have no protection. You are just long the stock.”

To minimize your risk even more, Harwood adds, you can buy a protective put on the stock, converting the strategy to a collar. 

He says it’s important to thoroughly understand the covered call strategy so you can make adjustments if needed. One idea is to sell covered calls on less volatile stocks, which can reduce the chances of unwanted surprises.

The chart below illustrates the risks and benefits of selling covered calls:

How Fidelity can help
To learn more about selling covered calls, consult Fidelity’s Trading Knowledge Center. You can also call a Fidelity options specialist at 800-544-6666. Before you are permitted to sell covered calls, a Level 1 option strategy, you must fill out an options agreement form and be approved for options trading. 

Introducing credit spreads
For many, selling covered calls is the only income-generating option strategy they will use. If, however, you are interested in more sophisticated option strategies, you might want to consider credit spreads. Spreads are the simultaneous buying and selling of options. Joe Burgoyne, director of retail marketing at the OIC, explains: “The definition of a credit spread is that you take in more capital than you put out.” Unlike the covered call strategy, he says, credit spreads don’t involve owning stock. The following are the two most popular credit spread strategies.

2. Bull put spread (bullish)
The strategy: An investor will sell put options at a specific strike price while also buying the same number of put options but at a lower strike price. The goal is for the price of the underlying stock to stay above the strike price of the short put, so the options expire worthless. The difference in price between the two options is the expected profit.

Selling a bull put spread is a strategy that aims for limited losses and limited gains. “You can sell one put at a strike price below but close to the current stock price,” Bittman explains. “Then you can buy a further out-of-the-money put to limit your risk. If the stock moves sideways or up, then both puts expire worthless and you keep the net credit received.”

Here’s a brief example of the bull put spread:

1. You sell one option contract of the 50 put for approximately $3.
2. You buy one option contract of the 45 put for approximately $1.
3. You receive a net credit of $2 per share, or $200 ($3 - $1 = $2).
4. If the stock goes up, or at least stays above $50 a share, then both legs of the spread expire worthless and you keep the $200.
5. If the stock moves down below $50 a share, you will lose money. The risk on this trade is limited. The maximum loss is $300. That's the value of the 50 put--$5,000--minus the value of the 45 ($4,500). These two contracts would result in a $500 loss, offset by the $200 in premium you get to keep. Of course, you might choose to close out of the position before you reach the maximum loss.  

Although risk is limited when using this strategy, there are dangers. Burgoyne explains: “There is a risk of assignment using these strategies. That is why investors must perform their due diligence to determine what could happen.”
If assigned, the option seller must buy the stock at the agreed-upon strike price. Keep in mind that assignment is not necessarily bad: some professional traders welcome early assignment.

Nevertheless, the key to avoiding problems, Harwood suggests, is to always monitor your option positions. “A lot of people jump into spreads without understanding the risk and reward profile,” he says. “These are not complicated strategies, but you must take the time to become educated.” Eventually, the goal is for investors to learn independently, he adds.

The chart below illustrates the bull put spread:

To learn more about selling bull put spreads, consult Fidelity’s Trading Knowledge Center. You can also call a Fidelity options specialist at 800-544-6666. Spreads are a Level 3 margin strategy, so previous options experience is required.

3. Bear call spread (bearish)
The strategy: An investor will sell call options at a specific strike price while also buying the same number of call options but at a higher strike price. The goal is for the price of the underlying stock to stay below the strike price, so the options expire worthless. The difference in price between the two options is the expected profit.

Here’s a brief example of the bear call spread:

1. You sell 1 December 50 call for approximately $3.
2. You buy 1 December 55 call for approximately $1.
3. You receive a net credit of $2 per share, or $200 ($3 - $1 = $2).
4. If the stock stays below $50 a share, then both legs of the spread expire worthless and you keep the $200.
5. Like all stock trades, there is a risk of loss. If the stock moves up, you still get to keep the $200, but you will lose up to $500 on the call contracts. (100 x 55 - 100 x 50). That will be offet by the premium, but you could lose as much as $300. Of course, you could close out of the position before the maximum loss.

When stocks are trending up, many traders prefer to initiate a bull put spread. But when stocks are trending down, some gravitate to selling bear call spreads.

Bittman explains this strategy: “Selling a bear call spread is for investors who are neutral to bearish on the market. They would sell a call with a strike price that is relatively close to the market and then buy a call that is further out of the money. If the stock moves sideways or down, and both calls expire worthless, they would keep the net credit received.”

Although it’s usually not an issue, Bittman agrees that one of the risks of credit spreads is the chance of early assignment. “Although it doesn’t happen often, you usually don’t want to be assigned. If you see the risks of assignment increasing, the logical course of action is to close the position and move on to the next trade.”

If you do get an early assignment, you will be required to short the stock at the agreed-upon strike price. Once again, there are exceptions; some professional traders welcome early assignment.

The chart below illustrates the bear call spread:

How Fidelity can help

To learn more about selling bear call spreads, consult Fidelity’s Trading Knowledge Center. You can also call a Fidelity options specialist at 800-544-6666. Spreads are a Level 3 margin strategy, so previous options experience is required.

Managing spreads
Bittman suggests that if you are new to using spread strategies, start small. “Beginners are intimidated by having multileg options strategies,” he points out. “Start with a small position to minimize risk.”

In addition, he suggests you avoid initiating credit spreads during stock earnings release periods. “When you do credit spreads, you want neutral price action, and more than likely, stocks will fluctuate around earning periods.”

To increase your knowledge, Burgoyne says you should always be a student of the markets. “To sell a call or put spread, you have an opinion of the underlying stock or index. You don’t enter these strategies randomly. It’s all about sitting down with the tools that Fidelity offers, or taking online education classes.”

Continuous education
Obviously, options are not for everyone, but after reading about these income-producing strategies, you might consider setting aside a portion of your portfolio to options. Links to the CBOE and OIC online classes and podcasts can be found at Fidelity’s Trading Knowledge Center.

Always be aware of the risks and rewards of any option strategy before entering a position. The key to being an informed option investor, as always, is through continuous education.

Options trading entails significant risk and is not appropriate for all investors. Certain complex options strategies carry additional risk. Prior to trading options, you must receive from Fidelity Investments a copy of "Characteristics and Risks of Standardized Options" by clicking on the hyperlink text, and call 1-800-FIDELITY to be approved for options trading. Supporting documentation for any claims, if appropriate, will be furnished upon request.

Michael Sincere is a freelance writer and author of six books, including Understanding Stocks (McGraw-Hill, 2003) and Understanding Options (McGraw-Hill, 2006).

Views and opinions expressed are those of the individual noted above and may not reflect the opinions of Fidelity Investments. These comments should not be viewed as a recommendation for or against any particular security or trading strategy. Views and opinions are subject to change at any time based on market and other conditions.

1. Under the wash sale rules, a loss on the sale of a security is disallowed if the same security or a "substantially identical" security is purchased during the 61-day period beginning 30 days prior to (and ending 30 days after) the sale of the security that resulted in the loss.