Investors seeking to generate income from equity portfolios on a regular basis can employ option writing strategies using puts and calls to buy and sell stocks. In addition to producing income, writing puts to buy stocks lowers the cost basis of the purchase. Covered call strategies generate income and can increase net sales proceeds. The following examines three ways to generate income on a regular basis using put and call writing strategies.
An option contract covers 100 shares of an underlying stock and includes a strike price and an expiration month. The buyer of a call option has the right but not the obligation to buy the underlying stock at the strike price before the contract expires. The seller of a call option, also referred to as a writer, is obligated to sell the shares of the underlying stock at the strike price if a buyer decides to exercise the option to buy the stock. In each option transaction, the amount paid by the buyer to the seller is referred to 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 two parties. In these contracts, the buyer of the put option has the right but not the obligation to sell the underlying shares at the strike price prior to expiration. If the buyer of the contract elects to sell the underlying shares, the option writer is obligated to buy them.
Options are referred to as being "in the money" when the price 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 money, the underlying shares are automatically called away from call writers (who are assigned to deliver the shares to those who exercised the option's strike price).
Selling Puts to Buy
Investors can generate income through a process of selling puts on stocks intended for purchase. For example, 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 option is trading at $3, the put writer receives a premium of $300, as the price of the option is multiplied by the amount of shares in the contract.
If the option expires in the money, 100 shares of stock are put to the writer for $75 per share. If the option expires while the share price is above the strike price of $75, referred to as being out of the money, the option writer keeps the premium and can sell another put option to generate additional income. This process is similar to using limit orders to buy shares, with one key difference. With a limit order at $75, a purchase is executed when the share price drops to or below that level. For a purchase to be executed using a put strategy, the option must expire in the money or the put buyer must elect to assign shares to the seller for purchase prior to expiration.
Writing Covered Calls
Shareholders can produce income on a regular basis by writing calls against stocks held in their portfolios. For example, with XYZ stock at $80, an investor holding 100 shares could write a call at $85. For an option trading at $3.50, the call writer receives the premium of $350. If the option expires out of the money, the call writer can sell another option against the shares to generate additional income. With an in-the-money expiration, shares are called away at the strike price. If the option is in the money prior to expiration, the call buyer can elect to call away underlying shares at any time.
The price of an option always includes some component of time value (extrinsic value), which is calculated by the amount of time to expiration, the proximity to the strike price, and the volatility of the underlying shares. In the examples using XYZ stock, both options are out of the money and are composed of only time value.
Premiums on options in the money also include an intrinsic value. For example, if XYZ stock goes to $90, the option premium on an $85 call includes $5 for the amount it is in the money, plus its time value. Time value declines the further away the share price is from the strike price.
The options with the highest time value are those with strike prices closest to the share price. A second consideration is the time to expiration, with more time resulting in higher premiums. For example, an option with six months to expiration might be priced at $6 per contract, while an option with three months remaining may be priced at $3.50. Generally speaking, longer expirations tend to have lower time values, as measured on a per-month basis, than shorter expirations.
These variables provide investors the flexibility to create option-income strategies to suit their objectives. For example, short-term traders may elect to sell options with expirations of one month or less, while buy-and-hold investors can develop strategies using expirations going out as far as two years.