Income Trading with Options

03/12/2013 1:00 pm EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

Watch and learn how to trade for income using options with expert Dan Passarelli.

These days traders are getting into options more than ever with income trades and directional trades.  Our guest today is Dan Passarelli to talk about income trading with options. So, Dan, give us some good examples of ways I can make additional income with options.

Sure.  A lot of people think about options as direction plays, if I'm bullish, I buy a call, I'm bearish I buy a put, but in sideways markets where you think the stock is not going to rise or fall, it's just going to trade kind of neutral, this is when we use a family of option strategies called income trades so one of the most basic income trades is a simple credit spread.  Now there are two legs to a credit spread and you can do them with calls or puts. 

With the call credit spread, you sell a call that's somewhat out-of-the-money and you buy a higher strike call that's further out of the money and the way it works is because you're taking in a net credit because you're selling the more expensive option, if at expiration the stock is below the strike price of the call that you sold, then both of the calls will expire and they'll no longer be in your inventory and the credit you initially received when you sold the spread remains yours to keep so that's your maximum profit.  Now, of course, if the stock goes the other way and it goes against you, rallies up above the short strike price, you can have a loss but your loss is limited and that's the real strength of these spreads is they have a maximum profit and they also have a maximum loss.

Now do you recommend owning the underlying when you're doing these strategies or can you do them just by themselves?

Now in this case, it's very common for traders not to have any position whatsoever in the underlying. 

Okay, and then give us some, a couple of ideas on a put side, perhaps, that you could do as well.

Sure.  A classic way that I like to play the put credit spread is on a stock where maybe it's been trading somewhat sideways, but it's sort of towards the bottom part of that channel.  It's sort of sitting down near support and maybe it bounced off support recently.  That's when I like to sell an out-of-the-money put, a little bit underneath support, at or underneath it, and then buy a further out-of-the-money put so there it's kind of the same situation.  As long as support holds and the stock is above support at expiration, you've got a profitable put credit spread. 

Alright, should I be, when I'm putting on the spreads, be willing to own the stock or should I only do this on underlyings that I want to own or want to be short on? 

Credit spreads like this are more trading oriented strategies rather than investing oriented strategies so you're probably not thinking about wanting to own this stock.  You're using options as the trading vehicle.  That's what you're trading so if you were an investor, you can make a case for saying, well, yeah, I'd like to maybe own this stock but that's kind of just mentally a whole different ballgame. 

Alright, what kind of reasonable expectations are there for the percentage yield or kind of additional gains each month I can expect from this kind of strategy?

This is kind of a tricky question because, market taker, my philosophy when I work with students is that everybody trades different.  Everybody sort of approaches the market with a different financial situation, a different risk tolerance, and different preferences for their risk reward so it's kind of a tricky one.  Some people like to play it very, very conservatively; they like to set up very, very high probability trades and therefore they make a smaller percentage, and some people like to be a little bit more aggressive and set up trades that have a slightly greater chance of failure, but because there's greater risk, there's greater reward. 

So you've got to really just understand what your own risk tolerance is, what you're willing to deal with on the downside, and make decisions that way.

Yep.

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