How to Generate Income with Options

12/05/2012 4:30 pm EST

Focus: OPTIONS

Alan Ellman

President, The Blue Collar Investor Corp.

Allan Ellman outlines several strategies for generating income with options.

My guest today is Dr. Alan Ellman and we’re talking about covered call strategies and who it’s right for.  So, Alan, talk about a covered call strategy.  Who should be using these?

Well, covered call strategies are great for average retail investors.  Once they learn the strategy, and when I say learn, I mean master it, not being pretty good at it.  What they can do then is generate a monthly cash flow into their accounts and have full control of the outcome.  Now, it’s also a great strategy for people that have an existing portfolio and they want to pump up the returns of that portfolio.  What they can do in that situation is right out of the money call options, generate additional cash into that account and in most instances, still hold onto that equity. 

And you talk about mastering it too, how long does it take to actually master it? 

Well, for an average retail investor that has very little knowledge about stocks and options, I’m going to say between three and four months to actually master the strategy.  Now, you’re going to have to do your education and due diligence during that timeframe, but once you do and you master all of the nuisances of the strategy and that means how to enter the position, how to manage the position, and how to exit the position, then you’ll be able to handle the strategy in almost all situations, even in bear markets. 

Can you give us an example of a good covered call strategy in terms of picking strike prices, expirations, that sort of thing?

Well, as far as expiration dates are concerned, I write basically one month options and the reason for that is I have more control over the underlying equity.  I may like it one month and not the other and also, you get the highest returns for one month options.  So that’s my preference in terms of expiration date.  Now, in terms of the strike price, at-the-money strike prices are a bullish position where you generate the highest initial profit but you get no upside potential of share appreciation and you get no downside protection of that initial profit.  Out-of-the-money strikes are the most bullish position for covered call writing because you don’t generate the initial return that you do for an at the money strike, but you’ll have the potential for share appreciation on top of the options profit that you generated.

Now, in-the-money strikes, is a strike that very few covered call writers use and it’s a mistake.  In-the-money strikes are great in bearish markets and if chart technicals are mixed as opposed to totally bullish.  What an in-the-money will do, it will generate time value or initial profit and then it will give you downside protection of that profit.  I’m not talking about the break even now, which is the total option premium.  I’m talking about protection of the initial profit of that option, which is basically the time value.  So the intrinsic value of the option protects the time value.  So let’s say if you’re concerned about the overall market, things going on in Europe, things going on with our politics here in the United States, you’re concerned in general about the market, or if you have an uptrending stock that’s showing some bearish momentum, you may want to write an in-the-money strike.  You’ll still get a great initial return and you’ll have protection of that return.

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