Using options is a great way to generate a consistent income for your portfolio. While there are a few different ways that options can be used to generate income, we will focus on 3 popular income strategies used by investors. When choosing which strategy to use, one must consider what their end goal is, what stocks are already owned and what direction the stock will move in the future. Before learning about these strategies, it is important to understand what time-decay means in the world of options and how this affects income strategies using options as well as how strike selection affects the income received for the seller of an option.

Time Decay (Theta)

Theta refers to the change in the option price with respect to time. As options have an expiration date, options will decay in price as time goes by. Theta tells us the rate at which an options price will decay with time. When buying options, it is best practice to get in and out of the trade as quickly as possible to minimize the effect of time decay eating away at your profits. On the other hand, theta works in favour of the option seller as it is in the seller’s best interest for the option to expire worthless. Furthermore, the speed at which the option price decays with respect to time is not linear. Assuming everything else is constant, weekly options decay more quickly than monthly options as there is less time for the stock to make a big move. This is shown in the graph below where the speed of time decay accelerates closer to expiration. Option sellers would benefit more from selling shorter dated options.

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‍Risk Tolerance and Strike Selection

The goal for option sellers is for the option to expire worthless. However, the closer the strike price is to the current market price of a stock, the more premium is received for the option seller. When choosing a strike price, the option seller should try maximize the premium received while also maximizing the probability of the strike price not being reached (so the option expires worthless). Options that have a low delta and have strike prices that are further away from the current price have a higher chance of expiring worthless, but also pay less premium. Options that have a high delta with closer strikes will pay more premium but will have a lower chance of expiring worthless. Selecting a suitable strike price is dependent on the risk tolerance of the option seller:

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Strategy 1: Selling Covered Calls

A covered call is the very popular way of generating an income through options. There are two steps required for an investor to execute this strategy – owning a minimum of 100 shares of a stock and shorting (selling) an “out of the money” call option. This income strategy is effective when there is a neutral or bearish sentiment on a stock. As the investor is the seller of the option contract, he/she receives an immediate income in the form of the premium paid by the buyer of the contract. Repeating this strategy generates a consistent yield while still owning the underlying stock. Here are some best practices for selling covered calls:

• The strike price should be above the current price. Use conservative strikes (15-20 delta)
• Sell short term options (3-7 weeks) as they have an advantage over long term contracts by avoiding earnings cycles

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Strategy 2: Cash Secured Puts

A cash secured put is simply selling a put option while setting aside cash to buy the stock in the case of assignment. This is slightly different to selling a naked put option where the writer of the put sits and hopes that price does not decline. The cash secured put is primarily considered to be a stock acquisition strategy but can also be an income generating strategy. As this strategy involves receiving a premium for selling a put option, the investor can generate a consistent income with this strategy. The motivation behind selling cash secured puts is usually to acquire the stock at a lower price than its current price. For example, if FB stock was trading at $100 and an investor shorted 1 FB 90 put for $1 per share, the investor would need to buy the stock in the event that the option is exercised. If the investor shorted a naked put option instead, the above scenario would be seen as a negative outcome as the intention of the investor was to profit from receiving the premium and not having to buy the shares. However, in this case, the intention of the investor using the cash secured put strategy is to acquire shares at a lower price and instead of originally having to buy FB stock at 100, the investor can buy them at 90. This also allows the investor to use the premium received to net the total cost of buying the shares at the strike price. The overall effective cost of buying each share is therefore reduced to $89 (90-1). 

This seems like a win-win situation for the investor. If the market price rallies, the investor profits from the premium received and if the price drops, the investor gets to purchase shares cheaper (which is the preferable outcome). However, there are situations where this strategy will not work. If the stock price were to plummet to $50 instead of having a short-term retracement, the investor would have a loss of $39 per share. In the worst case, if the stock price declines to zero, the maximum loss for this strategy is $89 per share. It is also important to consider the case of FB stock not retracing and immediately rallying. Although the investor receives a premium and is in a profitable position, the investor loses the opportunity to buy FB stock at 90 and instead would have to consider buying at a higher price. Here are some of the best practices for selling cash secured puts:

• The strike price should be below the current price. When choosing a strike price, it is better to take a more aggressive approach. As this strategy is a stock acquisition strategy, investors would want the option to be exercised even if they are short the put option. Picking a strike price closer to the current price increases the premium received and decreases the probability of the option expiring worthless. 
• Sell short term options (< 1 month).

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Strategy 3: Credit Spreads

Credit spreads can be used as an income strategy for when an investor has a modest bullish, modest bearish or neutral sentiment on a stock or ETF. This strategy should not be used when a stock or ETF is expected to make a large move. When an investor expects a bullish move for a stock, a bull put vertical spread is used. For example, suppose XYZ stock is trading at $100, the investor would:

• Sell $100 put @ $4 & buy $90 put @ $1
• The maximum reward for this strategy is $3 ($4-$1)
• The maximum risk for this strategy is $7 (the distance between the 2 strike prices)

If the investor has a bearish view on XYZ stock, a bear call vertical spread is used:

• Sell $100 call @ $4 & buy $110 call @ $1
• The maximum reward for this strategy is $3 ($4-$1)
• The maximum risk for this strategy is $7 (the distance between the 2 strike prices. 

When selling naked calls and puts, the investor generates income from the premium received, however, there is also unlimited downside risk. In the above examples, if the investor didn’t enter into a long position, the premium received would be $4 from selling the option.  Credit spreads are used to mitigate the downside risk at the expense of a slightly lower income received. Credit spreads also tend to have a higher probability of profit. Here are some best practices for selling credit spreads:

• Sell 1-month ATM strikes (50 delta) and buy OTM strikes (25 delta) to limit your risk
• Better used for ETF options instead of individual stocks as there is a lower probability of a large move.

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Summary

Long term stock investors should use cash secured puts to acquire the stocks they want to own at a lower price and then think of using covered calls to generate an income on those stocks that they now own. Investors that want to generate an income from speculating on the direction of a stock should use credit spreads. 

The key to generating a consistent income with the above strategies is to use a methodological approach based on best practices every cycle. Selling shorter dated options and repeating this process provides better results than selling longer dated options as the premium received is not linear to time. For example, selling a 1-month option that generates $1 of income on a stock does not mean you will receive $3 of income for selling a 3-month option. In reality, selling a 3-month option will generate less than $3 premium, therefore it is more profitable to sell 1-month options and repeat the process for 3 months. All 3 of the income strategies mentioned above work best with stocks that are less volatile. For this reason, earnings announcements should be avoided as this can cause stocks to make a big jump very quickly. 

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