What is an Option Income Fund

An option income fund, sometimes also known an option income closed-end fund (CEF) is a specific type of mutual fund. Its goal to generate current income for its investors by earning premiums from selling option contracts.

BREAKING DOWN Option Income Fund

Option income funds are usually best suited for tax-advantaged accounts because the profits those investors earn on the options sold are then taxed as ordinary income, rather than as dividends.

Option income funds offer clear rewards, with much higher returns. But such an income generating strategy can be much riskier than simply investing in dividend paying stocks.

That's why option income CEFs have both proponents and naysayers. For an example of the latter, see a 2005 Bloomberg article, titled "Option Income Funds: Watch Out." It argues that while payouts may be generous  low-yield times, there risks are great.

The Benefits of Option-Income CEFs

On the other hand, a 2012 piece in Kiplinger opined that "Option-Income CEFs May Be a Smarter Choice."

As Jeffrey R. Kosnett wrote that there are roughly 30 option-income CEFs, and they include everything from funds that focus on just the 30 stocks in the Dow Jones industrials to funds those that sell options on emerging-markets stocks.

He explained that there are some key advantages such funds. "Whatever their strategy, option-income CEFs share two virtues," said Kosnett. "First, all trade at discounts to their net asset value per share. Second, these funds are ideal for a market stuck in a fairly narrow trading range."

The reason, he said, has to do with covered-call strategies: "A call option gives its holder the right to buy, or call, a stock from the option's seller at a certain price by a certain date. Buying options is risky. But selling a call against a stock you own is a conservative strategy. By doing so, you limit the potential appreciation of your stocks, but you generate additional income through the sale of the options."

He further noted that "option-income funds designate much of their distributions as a 'return of capital,' a phrase that suggests you're not getting a true dividend. But just as there is good cholesterol and bad cholesterol, there are good and bad returns of capital. Cash inflows from option sales are repeatable and sustainable."