If an investor wants to generate a steady income from their portfolio, they may choose to purchase bonds or value stocks to receive interest or cash dividends. As more retail investors enter the derivative markets, the options-selling strategy is becoming a popular method for earning additional income.

We will discuss other uses of the strategy in this article as well—to keep it simple, let's focus on two basic option selling strategies: covered calls and cash secured puts.

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Adding Additional Income to Your Portfolio

• Do you buy stock in quality companies and hold it for long periods of time?
• Are you seeking ways to boost returns on idle cash in your account?

If this sounds like you, an options-selling strategy might get you where you want to go.

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First, let's start with the popular covered call strategy. A covered call is a moderately bullish strategy that involves selling call options on a stock that you already own. The intent of a covered call strategy is to generate income from the owned shares by selling call options on them. Compared to a naked short call position, your sold calls are covered because the two positions (owning the stock and selling calls) are offsetting. If the call is exercised, you can fulfill your obligation, because you already have the shares to sell.

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A cash-secured put is selling put options in a portfolio with enough cash set aside to cover the potential obligation. That's because when you sell a cash-secured put, you'll be obligated to buy 100 shares of stock if the put holder exercises the option. The benefit of the strategy is that you receive an upfront premium, which moderately or significantly increases returns on the cash position in your account.

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Cons: Short options can be assigned at any time up to expiration regardless of the in-the-money amount, which is referred to as "early assignment risk." The options seller needs to be comfortable with either selling their position at the strike price or buying the stock at the strike price at any time up to expiration. If not, they can buy back the option before expiration to close the short position. If the short option position becomes more expensive, it could result in a loss to the option writer if he chooses to close the position. Also, another risk of an option assignment is that shares acquired as a result of an assignment could decrease in price.

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Benefits of Covered Calls

An often-overlooked benefit to selling a covered call is that it can lower the cost of buying stock shares. How does it work?

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Let's say you wanted to purchase ABC stocks currently trading at $40. The premium of the 40-strike call option is $1.00 per contract. If you were to buy the 100 ABC shares and simultaneously sell one call option, what would happen if your short call option expired worthless?

This would be good news, as the net cost for every ABC share you bought would be $39 per share ($40 for the stock minus the $1 you receive for selling the call option). Compared to directly buying stocks, the covered call strategy can help reduce acquiring costs. This strategy can reduce the cost basis for long stocks, but there is always the risk that your call option will be assigned, and you’ll have to sell your position at the strike price.

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Sometimes, investors may use the covered call strategy to target a selling price for their stock shares above the current price. Suppose James is holding XYZ stock for the long-term, which is currently trading at $39.50. He wants to sell a portion of his holdings at a target selling price of $41. He sells one 40 Call for a $1 premium. If the covered call is assigned, James must sell the stock, in which case he will receive a total of $41 per share—the $40 strike price plus the $1 premium from selling the call. James can still get assigned even if the stock price only rises to $40.20. Once James is willing to sell stock at a given price, the covered call helps him target that objective, even if the stock price never rises that high.

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More Cons Explained

Limiting your potential gains from future stock price increases. Selling covered calls on your owned stocks automatically caps your profit. The covered call seller gives up the potential upside profit if the stock price rockets above the strike price. This is why covered calls are considered a moderately bullish strategy. A strongly bullish investor would expect price increases that outweigh the profit from a covered call premium.

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You can still take a loss. The two basic option-selling strategies are similar in terms of their risk/reward profile. Both limit potential upside in exchange for a higher probability of success by lowering breakeven price points. However, the risk of losing money is still there if the stock price declines more than the premium you received.

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Next Steps

Option selling involves trade-offs. Selling options can improve the return of a portfolio but may cap profit or even incur a loss. Different strike prices and expiration dates also involve trade-offs between risk and return.

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Before using your own funds, try options paper trading with different combinations to find the best fit for your trading style. Let's get started>>>