Generating income is one of the biggest challenges investors face today.
Interest rates on bank deposits and bonds have been meager for some years now. And although the Fed is threatening to raise rates this year due to rising inflation in the U.S,. the investment returns will not be exciting for quite some time.
BUT there is a way to create an income stream for your portfolio, even in this volatile economy: stock options.
Although options have been considered risky (due to the use of leverage and wild speculation by unsophisticated traders), they can be a safe, effective and powerful tool to generate income in your portfolio when used correctly.
And what is often overlooked, most investors can learn how to create income with options using relatively simple strategies.
Options Strategies to Generate Income
Generating income using options usually involves either a combination of options legs, or stocks and options legs.
Most of these income strategies include collecting premiums up front and then taking advantage of time decay (theta). When you sell options, time decay will be in your favor instead of working against you.
“Net credit” income strategies will typically have margin requirements. That means you need to have a certain amount of cash or marginable securities in your account as collateral before you can execute those trades.
As stated above, there are basically two types of combinations you can use:
1) The stock and options combination
You typically use this strategy to generate short-term income. This income is in addition to any dividends you might earn by owning the underlying shares.
Execute this strategy successfully and you will enjoy enhanced portfolio returns.
i) Covered Calls
The covered call is the most common stock-and-options-combination as it is the simplest and does not require margin as the long stock leg “covers” the short call leg.
You can use covered calls when you already own shares in a company.
The strategy typically involves selling out-of-the money call options on a stock that you already own. It is a no-brainer strategy to earn steady income on your long-term buy-and-hold stocks in neutral to mildly bullish market conditions.
ii) Covered Puts
The opposite of a covered call is the covered put.
This involves a short position on the underlying stock and another short position on the out-of-the-money (lower) strike price put option.
Both legs will require margin, making this a more complicated and higher perceived risk strategy than the covered call.
Therefore, only more advanced traders should consider covered puts
2) The multiple-options combination
These income strategies can be divided into two main categories: debit spreads and credit spreads.
i) Debit Spreads
Debit spreads involve buying and selling calls and puts for a net debit. They require no margin because you are net long options and paying up front for the position. This means you are buying the nearer-the-money (higher delta) option and selling the further away-from-the-money (lower delta) option.
Even though debit spreads require no margin, they do require the stock to move in your favor in order for them to be profitable.
These are better suited if you have longer time horizons so the stock has time to move in your favor.
Popular Debit Spreads
Diagonal spreads are reasonably beginner-friendly. However, great care needs to be taken to ensure you buy deep enough in-the-money and sell out-of-the-money. The key here is that the long leg needs enough delta to be profitable if the stock reaches the higher strike short leg and beyond.
Calendar spreads are popular due to their perceived high yield. But the less experienced trader can get trapped into a loss due to the vagaries of volatility.
Proper training for both the diagonal and calendar spreads is essential.
ii) Credit Spreads
Credit spreads involve buying and selling calls and puts for a net credit. They do require margin because you are net short options. This means you are buying the further-from-the-money (lower delta) option and selling the nearer-to-the-money (higher delta) option.
While credit spreads require margin, they typically do not require the stock to move in your favor in order for them to be profitable.
These are better suited for traders with shorter time horizons. This allows them to take best advantage of time decay.
Credit spreads are popular with brokers because they are short-term and regular, triggering commissions and order flow revenue. Traders should be aware that, credit spreads are NOT “set-and-forget” trades. If the stock price goes against you, you will need to actively manage the position with advanced knowledge of options volatility and time decay dynamics.
Popular Credit Spreads Strategy
The bull put spread tends to be the most popular credit spread as it is simple to understand and is for neutral-to-bullish conditions.
The bear call spread is the exact opposite, in other words, suitable for neutral to bearish conditions.
Other credit spreads such as the condor or butterfly can be used to generate income for sideways anticipated conditions.
But the question has to be asked: when do you ever have a deep conviction about a stock remaining rangebound?
These rangebound strategies require three or four legs and are best approached when “legged-in” from a simpler two-legged credit spread. Therefore, they are more suited to more advanced options traders.
The ‘Master Keys’ to Generating Consistent Income with Options
There are three Master Keys for generating consistent success in the markets, whether with stocks or options.
The first Key is Market Timing. These income strategies are best used when markets are neutral to bullish or neutral to bearish.
The second Key is Stock Selection. For example, if you want to raise short term income on a bullish stock, you’ll want to find a stock that you expect to rise modestly within the next month.
The third Key is the Trade Plan. You need to be aware of your goals and risk tolerance before executing any trade. Pick a strategy that you understand fully, that accomplishes your goals while remaining within your personal risk tolerance.
In conclusion…
By now, you should be getting a good idea that options can provide a lot of choices and flexibility.
In addition to generating income, you can use options to leverage your returns while actually lowering your risk. You can also deploy options to protect the positions in your portfolio against severe losses or volatility.
In this blog, we’ve only scratched the surface of the many benefits of options trading. It is the most fascinating area of the investment world.
But beware!
The subject of options needs to be taught properly, preferably supported with highly visual tools that help explain their unique characteristics correctly.
OptionEasy (by WiseTraders) has been developed to give traders a highly visual, dynamic and practical learning experience. It is the Premier options learning experience, used by professionals and amateurs alike.
We invite you to explore our website and discover more about the wonderful world of options … correctly!
