How to Sell Options for Income

07/12/2011 8:30 am EST

Focus: OPTIONS

James Bittman

Senior Instructor, Chicago Board Options Exchange

Selling options can be an ideal way to add income to your account, explains Jim Bittman, but there are some important risk factors for option sellers to consider.

My guest today is Jim Bittman, and Jim, I want to ask you about selling options. Some people say it’s way too risky. Is now the time to do that?

Well, Karen, there’s always a good time to sell options. If there’s a stock and you’re willing to buy at a target price, which might be below the current price, then you can sell a put option.

Strike minus put premium is the effective price at which you’re going to buy that underlying stock if the put is assigned.

Say there’s some $50 stock and you want to buy it at $48. If you can sell a 50-strike put for $2, then if that put is assigned to you, you have to buy the stock at $50, less the $2 premium you received, and then you get the stock at $48.

And that’s you wanted to do.

That’s what you wanted to do.

It’s always a good time to sell a put in that situation. You have the cash to buy the stock, and you’re willing to buy the stock at that level.

Same on the upside. If you own a stock and you know you want to sell it above the current market, then selling a covered call is a very low-risk strategy.

If the stock goes up, you get called away, which is what you wanted to do. If the stock doesn’t go up, we can get that money.

So you’re kind of getting paid to wait when you’re selling options.

Why then is selling options perceived by some to be such a risky strategy?

Well, the degree of leverage that is used. If you own stock for cash and you sell a covered call, then there’s no leverage in that strategy.

The problem is when people sell put options and they do it on minimum margin. They do not have the cash to buy the stock.

Maybe they’re using other stocks in their portfolio as a margin behind that short put option. In that case, the market goes down, they lose on the put, and they lose on the stock they’re holding as collateral for the put.

So they’re double losing. That’s when selling options gets to be too risky.

So you must know your leverage, you must know your exposure, and you have to be fully prepared to take that risk. Then selling options is not risky at all.

Know your leverage, know our exposure, and always be prepared to take the risk.

Right.

See related: The Problem with Income Option Trading

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