Earn Safe, Steady Income from Options

05/08/2012 11:15 am EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

Simple covered call strategies can be implemented to generate steady income in today’s market environment, says Dan Passarelli, describing risk factors to consider.

Options for income. We’re here with Dan Passarelli who is going to tell us the smart and safe way to use options to juice up your dividend yields.

A lot of times, I think investors perceive options to be a trading tool or something highly sophisticated that incurs a lot of risk, or it gets complicated in hedging your risk. Are there simple strategies for investors who have some high-yielding stocks or just nice dividend yields to juice up those returns without incurring a great deal of risk?

One of the most basic strategies that conservative investors tend to use is the covered call. It’s one of the first strategies that many traders even start out with.

Basically, a trader owns 100 shares of stock, usually as a long-term investment, and he also sells a call to create a two-part strategy. So long 100 shares and then short a call.

When you sell a call option, you’re selling it short. You don’t own it. You’re assuming a short position in the call. So when you think of an option as the right to buy an underlying security, that’s the definition of a call.

When you sell it, you’re effectively selling that right to someone else. So you incur an obligation to maybe have to sell your shares to the person who bought the call from you.

They’re the long piece of this trade, so to speak.

Right. Or you hear people refer to options as contracts, and make no mistake, that’s exactly what they are. There are two parties: one long, the owner; and one short, the person who sold it to you.

So back to the covered call; when a trader owns 100 shares of stock and sells the call, here’s how it works: they collect a premium for the call option, and that premium—no matter what happens—is theirs to keep.

It’s kind of like when your insurance company sells you an insurance policy. You pay them the premium, and they get to keep that no matter what happens. If you crash your car or if you don’t crash your car, they have $500 for the six-month period.

So that’s kind of how it works when you sell options. You collect a premium and it’s yours to keep. If the stock does nothing, then great; you own the stock, but because you have this extra cash, you lower the cost basis.

You might lose money if the stock falls too much, which is natural if you own a stock, but you’ll lose less than you otherwise would have because of that lower cost basis.

Now here’s the tradeoff: if the stock goes higher, you can make money on the stock going higher, of course, but only to a point. Because when you sell a call, you agree to sell the stock at a specific price: the strike price.

If the stock goes above the strike price, it’s in the person who bought the call’s best interest to exercise the call and therefore have you assigned, or make you sell that stock that you own at that price, which might not be a bad thing. Because if you bought the stock at, say, $50, and you have to sell it at $55, and you get to keep the option premium, you have a winning trade.

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