Using Options to Generate Income

Asad Dossani
25th September 2014: The NSE futures and options turnover makes a record high of 5,32,612 crores.

Most investment strategies aim to do one of two things.The first is to protect and grow wealth.When we invest in long term assets like stocks, our goal is to increase wealth over time.At the same time, we diversify our portfolios into other assets like gold to also protect our wealth when time are bad. Or we can use put options to protect our portfolios.

The second type of investment strategy aims to do something quite different.And that is to generate income. Generating income means our investment strategy gives us positive cash flows on a regular basis. And there is an excellent options trading strategy that does just this.

Suppose you own a stock trading at 100.And since you own the stock, you naturally think it is going to rise over time.But now further suppose that you think the stock will rise, but you don't expect it to rise very much.

Let's say that over the next three months, you don't expect the stock to rise beyond 105.This could be for many reasons.Perhaps bad macroeconomic news is affecting stocks negatively.Or perhaps the company is going through a temporary rough patch.

Is there any way in which we can take advantage of this view?Well, if all you could trade was the stock itself, then you can't take advantage.But if you can trade options on the stock, it's a different story.With options, you can make money based on your view.

How do we do this?We implement a Covered Call strategy.This strategy sells an out of the money call option on a stock that we own.In our example, suppose there is a call option with a strike price of 105 that expires three months from now.And suppose that this call costs 3.What do we do?

We sell the call option for an instant premium of 3.And then we wait for the option to expire in three months.Our profit and loss at the end of three months depends on where the stock price ends up, and what the option is worth at expiry.

The best case scenario is that the stock rises to 105, but not more than that.If the stock expires between 100 and 105, we make a profit form the stock.The call option that we sold expires worthless if the stock is below 105.And so we pocket the premium of 3 that we collected earlier.

If the stock closes above 105, we lose money on the call option and simultaneously make money on the stock.And beyond 105, the profit from the stock exactly offsets the losses from the call.In fact, it does not matter how far beyond 105 the stock ends up.We make profits of 0 once the stock goes beyond 105.

If the stock price falls below 100, then we lose money on the stock.But we do keep the option premium that we earned, so the losses are not as bad.

Can you see what is going on here?When we implement a covered call, we lose the upside of the stock.That means that if the stock rises very high, we don't earn profits from this.But what we gain in return is the option premium.So we are giving up potential upside in exchange for current income.

And this is how we can use options to generate income.By writing covered calls, we can earn additional income at the expense of giving up the upside to the stock.

When is this a good strategy to implement?Precisely when you think the stock isn't going up very much.If the upside is unlikely to occur, then a covered call will make you money.It will give you additional income now that you can use to reinvest, or save in your bank account.And with record breaking volumes hitting the options markets, now is a great time to learn more.

Have you implement a covered call strategy in the past?Share your views in the Club or share your comments here.

P.S. Our e-learning course Derivantage has great insights on how options work and what kind of trading strategies you can implement.I do encourage you to check it out.

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7 Responses to "Using Options to Generate Income"
ramchandra varma
15 Oct, 2014
I am stock select subscriber.In my opinion small cap/mid cap/multi baggers recommendations may be given accessible so for I am not much benefited with the subscription.There fore I am not willing to accept the life time subscription of stock select.I regularly read your profit hunter but not much explanation about the practical market transactions with recent examples.Recently I come to know that DLF Ltd.has been punished and its share price gone down side by 30%.If purchased put of same at Rs.140 or below would have benefited.Thanks.Like (1)
Vipin Chandok
13 Oct, 2014
It needs to be appreciated that any strategy concerning stocks has risks inherent in it, which can be either facing losses or giving up on the potential gains. Even the stragtegy of buying and holding has its own risks. Two further actions can be undertaken as an extension of the strategy: One, if the stock price goes above Rs 105 in the example under consideration, then a Futures of that stock may be purchased. The loss stemming from the sale of the option at strike price of Rs 105 would be offset ny the Futures so purchased. The only issue is what if the stock price falls below Rs 105 after the Futures is purchased? This can be addressed by selling the Futures as soon as the stock goes below Rs 105. If the stock is volatile and moves above/below Rs 105 multiple times, this would need to be done as many times. While in theory this appears a sound strategy, the impact costs would be high. The Rs 3 received by sale of the Rs 105 call would come in handy. Second, if it is expected that the stock will not go down much below Rs 100, then a Put Option of Strike Price of Rs 95 can be also sold, say, for Rs 3. If at the expiry the stock is between Rs 95 and Rs 105, you will pocket Rs 6. If the stock goes below Rs 95, then the strategy in One above can also be used; that is, Futures of that stock can be sold. The fall out of the above is that the option sales will lead to higher volumes for you if Futures have to be purchased / sold as a safeguard. Plus, one would need to constantly monitor the stock price movements.Like 
P. Sriramulu
06 Oct, 2014
I do play on options in the lines suggested by you. Your article is quite educative and comprehensive. My friends are of the view that since they don't get time, they don't indulge in options. I suggest to them they can easily play on options particularly if they hold stock options. One should get over the fear in playing on options and also be careful if it is not a covered call option hedging on the shares which he holds them already. They just have to devote an hour in a month. Thanks SriramuluLike 
sudhir vasudeva
02 Oct, 2014
I have sold 2 calls, of TITAN IND at strike price 430 for 1.55, these stocks are held by me; the price of the stock looks to go above 430 by expiration date 30 Oct, What strategy should I adopt to minimize the loss which may occur once the stock goes above 430 or still make it more profitable.Like 
bhogendranath n c
01 Oct, 2014
Practically I dont see any worthwhile information other than asking the people to register for report where are practical recommendations give by profit hunter? cheap publicity should be avoided I you wish to provide some free service, pl do the same without beating around bushLike 
Ashok Singhal
01 Oct, 2014
Hello, i m not intererested in Put n OptionsLike 
sn malhotra
30 Sep, 2014
The loss at times could be large if the stock, contrary to expectation, goes through the roof. So there should be a 2nd part to this strategy which can be put to action when the stock rises vertically.Like 
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