Generating Income Through Options

Study Notes:

An investor can use several option strategies to generate income, the two most popular are selling covered calls and selling cash secured puts. Each strategy has its own risk and rewards, and the examples in this lesson do not take into consideration other fees and costs like commissions that may impact profit and loss calculations. There is also a risk of early assignment when selling options, for more on exercise and assignment please see the lesson in this course.

What is a covered call?

An investor who owns shares of stock may write or sell calls against the position to generate income.  The overall shares owned by the investor must equal or be greater than the stock equivalent of the calls sold so that the calls are “covered” by the stock position. By selling the calls the investor generates income through the premium taken in.

For the next three scenarios let’s assume that the investor owns 100 shares of ABC stock, which they purchased for $45 a share and it is currently trading at $50. The investor currently has an unrealized profit of $500.

The investor believes that ABC stock will continue to rise over time, but they would like to generate some income from their position.  The investor can sell 1 ABC 55 call for $1 and bring in $100 dollars of revenue from the premium.

Scenario 1: At expiration ABC stock is trading at $54, the investor has a realized profit of $100 from selling the calls and an additional unrealized profit of $400 ($900 total) from ABC stock increasing from $50 to $54. The investor may choose to sell another upside call for a future expiration to continue to bring in additional income. This is the scenario that a covered call writer is looking for, the underlying to steadily increase but not past the call strike at expiration.

Scenario 2: At expiration ABC stock is trading at $50, the investor has a realized profit of $100 from selling the calls and no additional unrealized profit from the $500 prior to selling the covered call, but they still own the stock and may choose to sell another upside call for a future expiration to continue to bring in additional income. This scenario is also favorable to the covered call writer, as they have realized a profit of $100 while their overall position value has remained the same prior to selling the call.

Scenario 3: At expiration ABC stock is trading at $45, the investor has a realized profit of $100 from selling the calls and has now lost the unrealized profit of $500 they had when ABC stock was trading at $50. They still own the stock and may choose to sell another upside call for a future expiration to continue to bring in additional income. While the investor has taken in $100 of realized profit from the sale of the call, they would have been better off selling ABC stock at $50 for a realized profit of $500 versus $100.

Scenario 4: At expiration ABC stock is trading at $40, the investor has a realized profit of $100 from selling the calls and has now not only lost the unrealized profit of $500 they had when ABC stock was trading at $50 but has an unrealized loss of $500. They still own the stock but currently have an overall loss of $400 ($100 realized profit and $500 unrealized loss). They may decide to sell an upside call but should keep in mind their entry point of $45 for ABC stock. The investor is now in worse shape than prior to selling the call. They realized $100 profit from selling the call but overall, their stock position is now showing a loss of $500 whereas if they sold at $50, instead of selling the covered call they would have realized a profit of $500.

Scenario 5:  At expiration ABC stock is trading at $60, the investor has a realized profit of $100 from selling the calls, however the stock has been “called” away from the investor at $55 and the investor also has a realized profit of $1,000 from selling the stock for an overall realized profit of $1,100. While the investor profited nicely from the rise in stock the downside to this scenario is that if the investor did not sell the call, they could have sold ABC stock for $60, realizing a profit of $1,500 instead of $1,100.

What is a cash-secured put strategy?

An investor who sells cash-secured puts will take income in through the premium of the downside put sale. If the stock is below the strike price at expiration the investor must decide whether they want to take delivery of the stock: paying for it at the strike price above where it’s trading at in the market, close out the option position: possibly for a loss, or roll the put position to another expiration. Many investors use this strategy when they have identified a price point that they are willing to pay for a position in the underlying and sell the puts at that strike price, if the underlying drops to or below the strike price at expiration they take delivery of the stock at a price they are willing to pay for a long-term investment.

For the next three scenarios let’s assume XYZ stock is currently trading at $100 and the investor sells 10 95 strike puts expiring three weeks from now, taking in a premium of $2 a contract for a total of $2,000 ($2 x 100 x 10) 

Scenario 1: At expiration XYZ stock is trading at $98. The 95 puts expire worthless, and the investor makes a profit of $2,000.

Scenario 2: At expiration XYZ stock is trading at $94. The investor gets assigned the puts and must pay $95 a share for XYZ. The investor can decide whether they want to hold onto the stock or sell it in the market at $94 a share. In this scenario the investor has made $2,000 in realized profit on the sale of the puts but has $1,000 in losses realized if they sell the position at $94 or $1,000 in unrealized losses if they hold onto the position. If they sell at $94 the investor will have a total of $1,000 in realized profit ($2,000 – $1,000). Whether the investor holds onto their position of XYZ stock depends on their future outlook of the stock and whether they feel it is a good investment at the $95 price level.

Scenario 3: Prior to expiration unexpected negative news comes out on XYZ stock and the price drops to $65. The investor is assigned the 95 puts early and must buy $1,000 shares paying $95. The investor has made $2,000 in realized profit in the sale of the puts but now has unrealized losses of $30,000 and has had to purchase the stock earlier than expected. While the investor may have initially thought that $95 was a good price point to buy XYZ, they most likely feel differently after the negative news was realized and the stock is trading at $65.

Like every option strategy there is risk and rewards for strategies that generate income. It is important for the investor to understand the risks associated and plan accordingly.