A:

One strategy for earning income with derivatives is selling options to collect premium amounts. Options often expire worthless, allowing the option seller to keep the entire premium amount. Although there is a decent opportunity for profit, selling options can entail a substantial amount of risk. Derivatives are financial contracts whose value is derived from underlying assets. Options, along with futures contracts and forward contracts, are some of the most common types of derivatives.

An option on a stock or exchange-traded fund (ETF) is a financial contract granting the buyer the right to purchase 100 shares of the underlying security at a certain strike price until the option’s expiration date. The option buyer is not required to exercise the option. The seller of the option is collecting a premium as compensation for the obligation to deliver the shares to the option holder if the option is exercised. By selling options, an investor can collect premium amounts as an income stream.

There are many different option selling strategies. One option strategy is selling covered calls. An investor who owns shares of a stock can sell call options with a strike price above the current trading price to collect the premium. If the option expires in the money, there is a likelihood the investor will need to deliver the shares to the option holder. If the price of the stock stays below the strike price until the option’s expiration date, the investor gets to keep the entire amount of the premium. This is a strategy with limited risk since the investor owns the shares of the underlying stock.

Selling naked options is another strategy that has unlimited risk. An investor sells options with no position in the underlying security and no other option to hedge the risk. If the option expires worthless, the investor gets to keep the entire premium amount. However, if the price goes against the sold option, losses can be substantial. (For related reading, see "Are Derivatives a Disaster Waiting to Happen?")

RELATED FAQS
  1. How do I change my strike price once the trade has been placed already?

    Learn how the strike prices for call and put options work, and understand how different types of options can be exercised ... Read Answer >>
  2. When holding an option through expiration date, are you automatically paid any profits, ...

    Holding an option through the expiration date without selling does not automatically guarantee you profits, but it might ... Read Answer >>
  3. How Do Speculators Profit From Options?

    Options are a risky game, but you can learn speculators' tricks to use them to your advantage. Read Answer >>
  4. What occurs when a security meets its strike price?

    Learn more about the moneyness of stock options and what happens when the underlying security's price reaches the option ... Read Answer >>
Related Articles
  1. Trading

    Getting acquainted with options trading

    Learn about trading stock options, including some basic options trading terminology.
  2. Trading

    Options Strategies for Your Portfolio to Make Money Regularly

    Discover the option-writing strategies that can deliver consistent income, including the use of put options instead of limit orders, and maximizing premiums.
  3. Trading

    Beginners Guide To Options Strategies

    Find out four simple ways to profit from call and put options strategies.
  4. Trading

    Options Hazards That Can Bruise Your Portfolio

    Learn the top three risks and how they can affect you on either side of an options trade.
  5. Trading

    Trading Options on Futures Contracts

    Futures contracts are available for all sorts of financial products, from equity indexes to precious metals. Trading options based on futures means buying call or put options based on the direction ...
  6. Trading

    Cut Down Option Risk With Covered Calls

    Covered call writing has pros and cons, If used with the right stock, they can be a great way to generate income. Learn this strategy today.
  7. Trading

    A Quick Guide To Debt Options

    Options on debt instruments provide an effective way for investors to manage interest rate exposure and benefit from price volatility, learn more today.
RELATED TERMS
  1. Listed Option

    A listed option is a derivative security traded on a registered ...
  2. Option

    Options are financial derivatives that give the option buyer ...
  3. Currency Option

    A contract that grants the holder the right, but not the obligation, ...
  4. Vanilla Option

    A vanilla option gives the holder the right to buy or sell an ...
  5. Exotic Option

    An exotic option is more complex or has a different structure ...
  6. Far Option

    The far option in a spread trade is the option with the longer ...
Trading Center