What Is an Option Income Fund (CEF)?

An option income fund, also known as an option income closed-end fund (CEF), is a type of pooled investment whose goal is to generate current income for its investors by earning premiums from selling option contracts. This can be done by selling delta-neutral options strategies such as straddles or strangles, or by writing covered calls, among other more complex strategies.

Key Takeaways

  • An option income fund, or CEF, generates returns for investors through selling (writing) options contracts.
  • A CEF will employ relatively low-risk strategies that can generate steady income streams without much exposure to market direction.
  • Because they create regular income flows, CEFs are most impactful in tax-exempt accounts like Roth IRAs.

Understanding Option Income Funds

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.

One way these funds generate income is to sell options strategies that are delta-neutral, meaning that they do not change in value as the market moves either up or down. A short straddle is an options strategy comprised of selling both a call option and a put option with the same strike price and expiration date. A strangle is similar, but uses calls and puts at different strike prices instead. It is used when the trader believes the underlying asset will not move significantly higher or lower over the lives of the options contracts. The maximum profit is the amount of premium collected by writing the options. The potential loss, however, can be unlimited if the market moves significantly, so it is typically a strategy for more advanced traders.

A covered call is another common strategy, where an upside call is sold against an existing long position in the same underlying. When using a covered call strategy, the portfolio can still lose money if the underlying asset falls in price, and the maximum profit to the upside is also limited. If the asset's price stays relatively flat, however, a covered call strategy can be a relatively low-risk income generator.

Option income funds offer clear rewards, including higher returns than standard funds. But such an income generating strategy can also be much riskier than simply investing in dividend paying stocks. Because they utilize options contracts, there are several more risk factors

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, their 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 to 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."