Investors looking for to generate income from equity portfolios regularly can employ option writing strategies using puts and calls to purchase and sell stocks. Along with producing income, writing puts to purchase stocks lowers the fee basis of the acquisition. Covered call strategies generate income and may increase net sales proceeds. The next examines 3 ways to generate income regularly using put and call writing strategies.
Option Basics
An option contract covers 100 shares of an underlying stock and features a strike price and an expiration month. The client of a call option has the proper but not the duty to purchase the underlying stock on the strike price before the contract expires. The vendor of a call option, also known as a author, is obligated to sell the shares of the underlying stock on the strike price if a buyer decides to exercise the choice to purchase the stock. In each option transaction, the quantity paid by the client to the vendor is known as the premium, which is the source of income for option writers.
Put options cover 100 shares per contract, have a strike price and expiration date, but reverse the buy/sell agreement between the 2 parties. In these contracts, the client of the put option has the proper but not the duty to sell the underlying shares on the strike price prior to expiration. If the client of the contract elects to sell the underlying shares, the choice author is obligated to purchase them.
Options are known as being “in the cash” when the worth of the underlying stock is above the strike price of a call option or is lower than the strike of a put option. When options expire in the cash, the underlying shares are mechanically called away from call writers (who’re assigned to deliver the shares to those that exercised the choice’s strike price).
Selling Puts to Buy
Investors can generate income through a means of selling puts on stocks intended for purchase. For instance, if XYZ stock is trading at $80 and an investor has interest in purchasing 100 shares of the stock at $75, the investor could write a put option with a strike price of $75. If the choice is trading at $3, the put author receives a premium of $300, as the worth of the choice is multiplied by the quantity of shares within the contract.
If the choice expires in the cash, 100 shares of stock are put to the author for $75 per share. If the choice expires while the share price is above the strike price of $75, known as being out of the cash, the choice author keeps the premium and may sell one other put choice to generate additional income. This process is analogous to using limit orders to purchase shares, with one key difference. With a limit order at $75, a purchase order is executed when the share price drops to or below that level. For a purchase order to be executed using a put strategy, the choice must expire in the cash or the put buyer must elect to assign shares to the vendor for purchase prior to expiration.
Writing Covered Calls
Shareholders can produce income regularly by writing calls against stocks held of their portfolios. For instance, with XYZ stock at $80, an investor holding 100 shares could write a call at $85. For an option trading at $3.50, the decision author receives the premium of $350. If the choice expires out of the cash, the decision author can sell another choice against the shares to generate additional income. With an in-the-money expiration, shares are called away on the strike price. If the choice is in the cash prior to expiration, the decision buyer can elect to call away underlying shares at any time.
Maximizing Premiums
The worth of an option at all times includes some component of time value (extrinsic value), which is calculated by the period of time to expiration, the proximity to the strike price, and the volatility of the underlying shares. Within the examples using XYZ stock, each options are out of the cash and are composed of only time value.
Premiums on options in the cash also include an intrinsic value. For instance, if XYZ stock goes to $90, the choice premium on an $85 call includes $5 for the quantity it’s in the cash, plus its time value. Time value declines the further away the share price is from the strike price.
The choices with the best time value are those with strike prices closest to the share price. A second consideration is the time to expiration, with more time leading to higher premiums. For instance, an option with six months to expiration could be priced at $6 per contract, while an option with three months remaining could also be priced at $3.50. Generally speaking, longer expirations are inclined to have lower time values, as measured on a per-month basis, than shorter expirations.
These variables provide investors the pliability to create option-income strategies to suit their objectives. For instance, short-term traders may elect to sell options with expirations of 1 month or less, while buy-and-hold investors can develop strategies using expirations going out so far as two years.