Reasonably Thinking

Income producing strategies allow the investor to take equity risk and be rewarded with a known amount of income.  The two most basic income strategies are writing a covered call and selling a cash secured put.  First, writing a covered call is simply selling (writing) a call option on a stock that the investor already owns.  By selling a call option that is out of the money (the strike price is higher than the market price), the investor accepts a premium and forgoes potential stock upside.

An example:  stock ABC is $51.  An investor who owns 100 shares of ABC sells a call option at strike price $55, for six months in duration, for $1.20 per contract ($120).  As the six months comes to the end, the following outcomes can occur:

• Stock ABC falls or fails to exceed the $55 strike price.  The investor keeps the $120 premium and retains his 100 shares of ABC.  The investor is $120 richer than had he held onto the shares and didn’t sell the call option.
• Stock ABC rises past the strike price of $55.  The investor keeps the $120 premium and his shares of stock are sold at the strike price of $55, which nets the investor an additional $400 (100 shares times the difference of $55 – $51).  However, selling the call option is a double edged sword—if the stock really takes off (say it goes to $60 a share or higher), the investor is still forced to sell his shares at the strike price ($55).

(image from Options Industry Council)

The second income producing strategy is selling a cash secured put.  This is simply selling a put option on a stock and having enough cash to purchase the stock if it is assigned.  Here an investor can say, “I don’t think stock ABC will fall below $45 in the next six months” or “I’d be willing to purchase stock ABC if it fell to $45.”  By selling a put, the investor accepts the option premium (let’s say $140) and secures the position by holding $4,500 in cash in his account ($45 times 100 shares).   As the option’s duration approaches expiration, the following outcomes can occur:

• Stock ABC rises or stays above the $45 strike price.  The investor keeps the $140 premium and his $4,500 cash position remains untouched.  The investor is $140 richer than had he not sold the put option.
• Stock ABC falls below the strike price of $45.  The investor keeps the $140 premium and must use his $4,500 cash position to purchase 100 shares of ABC stock at the strike price of $45.  The investor may want to purchase a stock, but by selling a put, he is essentially paid to wait for it to fall first and then purchases it at a lower price.

(image from Options Industry Council)