When it comes to the stock market, there’s investing and there’s trading. While many people invest their money for the long term, some trading strategies can generate income in the short term. One way to do that is by trading options. A key to getting steady income with options is by making net gains over several trades while mitigating risk. We will cover seven options strategies for income. But first, let’s define some different types of options and positions.
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Calls and Puts: Options Trading 101
Options are a type of derivative contract that gives the holder the option to buy or sell an asset within a certain timeframe. They’re used to hedge on the price of the asset in the future. Traders pay a premium for the contract. If the asset’s value moves one way, the trader can profit significantly. If it moves the other way, they’re only out the cost of the premium.
There are two types of options: calls and puts. Call options are contracts traders sign, giving them the right to buy in a specific timeframe, whereas put options give traders the right to sell.
Positions: Short, Long and Neutral
A large part of options trading is the position you take on an asset. Your position could be to short a stock, which means you’re predicting it will go down in value. Or you could hold a long position, expecting it to grow in value. There are also ways to trade options from a neutral position, where the trader expects the asset’s value to remain consistent
Now that we’ve defined some of the basics, let’s cover seven ways traders use options to generate income.
7 Options Strategies for Income
Here are seven ways you can use options to generate income. Some are more complex than others. Some also require more capital or assume more risk. We’ll start with a couple basic strategies first, then move towards more complex ones.
1. Covered Calls
A covered call is a strategy used by options traders to hedge against the risk of a long position. With a covered call, a trader makes two actions: they buy shares in a stock, then they sell a call options contract to buy the shares for a premium. No matter what happens, the trader keeps the premium for selling the call option. This offsets any losses if the stock price drops.
However, the downside is that the trader may have to sell if the owner of the options contract exercises their right to buy. The covered call puts a cap on profits if the stock grows and hits the strike price for the options contract buyer.
2. Married Puts
A married put, also known as protective put, is a strategy similar to a covered call, but with a slight difference. With a married put, you own shares in a stock as well a put option to sell them. Let’s work through an example.
You think a stock’s value might rise in the next six months but don’t want to be in the red if it plummets. So you use a married put. In January, you buy 100 shares of Stock 123 at $20 each, for a total of $2,000. You simultaneously buy a put option to sell if the stock drops below $17 in six months. You pay a $1 premium for this put option, so you’re out $100.
If the stock ticks up to $25 a share by the end of six months, you made $450 when accounting for the option premium. Where the married put helps you is if the stock drops. Say it drops to $15 a share. You can exercise your option to sell at $17 a share. Instead of losing $500 by selling at $15 a share, you’re only out $400 (selling at $17 a share, plus the $100 cost of the put option).
3. Protective Collar
A protective collar is when you own a stock and sell a covered call while also buying a protective put. A protective collar works well with a neutral position that wants to hedge against the stock dropping. It comes at very little risk.
The premium you pay for buying the put option can be offset by selling the call option. In fact, one way a protective collar can generate income is by selling the call option for slightly more than what you paid for the put option. If the stock price remains neutral and the strike price on the call isn’t met, you gain a small profit regardless of stock movement.
4. Strangle Option Strategy
The strangle option is an options strategy used with multiple options contracts when you think you know the direction an underlying asset is headed in. A strangle strategy starts by buying a call option and a put option on an asset with the same expiration date.
For example, say Stock Y is trading for $45. You buy a call option to buy 100 shares of Stock Y at $50 each on January 1. You also buy a put option to sell 100 shares of Stock Y at $40 each on January 1. When January 1 comes around, if Stock Y is trading at $55, you buy 100 shares at $50 and sell them for $55 each, netting the difference minus the premiums paid for the options. If January 1 comes and the shares are trading for $35, you can sell them for $45, pocketing the difference minus the cost of the premiums
The risk with a strangle is the cost of the premiums paid on the options contracts. You have to pay them upfront. Plus, if neither strike price is hit, or if the difference isn’t great enough to offset the premium, you’ve lost money.
5. Straddle Option
Another options strategy for income is the straddle. In this strategy, you also buy a put and a call option for the same underlying asset and expiration date. A straddle differs from a strangle in that you buy the put and the call for the same strike price. With a straddle, you expect the asset to move, but you’re unsure which way it will go.
Like with a strangle, the risk involved is the premiums you pay for the options contract. The underlying asset has to be volatile enough to offset the costs of the contracts. However, if the asset climbs significantly past the call strike price, there’s little limiting profitability. And if the asset plummets, you can end out in the black.
6. Iron Condor
Number six on the best options strategies for income list comes with a very memorable name: the iron condor. This strategy is built from four contracts, combining two short positions and two long positions. Unlike a straddle, the iron condor works best when you expect low volatility.
With an iron condor, you’re going to buy a call and a put option, and sell a call and a put option. For example, Stock R is trading at $50. You buy a call option for $60 and a put option for $40, both expiring January 1. You also sell a call option for $55 and a put option for $45, also expiring January 1.
Where you make your money with an Iron Condor is the premiums. It costs more to buy an option that’s more likely to hit the strike price. Since your long options are further away from the current stock price, you’re paying a lower premium for them. The premiums you earn by selling the call and the put are what drive profit. Your goal with the iron condor is low volatility. As long as no strike price is hit, the contracts will expire and you’ll gain income off the premiums.
7. Iron Butterfly
Our last on the list of options strategies for income is the iron butterfly. Like the iron condor, the iron butterfly is a great strategy when you expect low market volatility. They are structured similarly with four contracts: a long-call, long-put, short-call and a short-put. The difference with the iron butterfly is that both short contracts are sold at the same price.
For instance, you have the same Stock R. Both the call option and the put option that you sell would be at $50 with an iron butterfly. There’s in-the-money and out-of-the-money but the standard iron butterfly sells at-the-money. Why? Premiums. Since it’s nearly guaranteed the strike price will be hit, you can charge a much higher premium.
The goal then is to gain enough from the sale of the options to offset any fluctuation in the market.
Bottom Line
Options trading is complex. To be successful at it, you need to know several tactics and do your research. Success in options is as much about protecting against risk as it is picking good positions. It’s a numbers game where you will lose on some trades – the key is just to win more than you lose. With these seven strategies, you can cover a lot of ground to earn income through options trading.
Tips for Investing
- Before diving into options trading, consider talking with a seasoned financial advisor. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- One of the most useful tools investors have is an investment calculator, which helps portfolios maintain the desired balance among asset classes.
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