Option income strategies can be used to increase the yield of an equity portfolio by generating a consistent stream of income and by allowing for discounted stock purchases. This post will cover which options strategies to use based on your primary goal, how to implement these strategies and best practices to maximize their effectiveness. Investors looking to generate a consistent income on their existing equity positions can sell Covered Calls while investors wishing to obtain stock at a discount from the current market price while generating income can use Cash Secured Puts.

What is a covered call?

A covered call is the most 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, bearish or moderately bullish sentiment on a stock. The investor receives an immediate income by selling the call option. Once the contract expires with the share price below the strike price,  the strategy can be rinsed and repeated to form a consistent income stream.

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Deciding on a suitable strike price

An investor selling a covered call would look for an out of the money (OTM) strike price. In the case of selling a call, an OTM strike price would be higher than the current market price of the stock. For example, if $BMO was trading at 100, an investor would want to sell a call option with a strike price that is significantly higher than the current price. Usually, a 15-20 Delta strike would be suitable. The more OTM the call option is, the less premium would be paid to the seller as there is a lower probability of the stock price reaching the strike price within the life of the contract. Picking a strike price that is close to the current market price of the stock may be tempting as there is a higher premium received, but there is also a higher probability of the stock reaching the strike price during the life of the contract. 

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Best Practices for Covered Calls

Selling short term options (45 days) tend to provide better results. Short term option contracts have an advantage over long term contracts due to earnings cycles. Longer term options are exposed to more earnings releases that causes them to be subject to large price movements. As mentioned earlier, an investor using a covered call strategy would find it beneficial to use an OTM strike price as there is a lower probability of the stock to reach that price. However, OTM strike prices and premium received have an inverse relationship. 

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What is a Cash Secured Put?

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 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 an income with this strategy. However, due to high downside risk and a large margin requirement, it should only be used on stocks that the investor wants to purchase. 

The motivation behind selling cash secured puts is usually to acquire the stock at a lower price than its current price. For example, if $BMO stock was trading at $100 and an investor shorted 1 BMO $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 BMO 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 effective cost of buying each share is therefore reduced to $89 ($90-$1). 

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Best Practices for Cash Secured Puts

There are 2 things to consider before implementing a cash secured put strategy:

• Time to expiration – Due to time decay (theta), options lose value the closer they get to expiry. Options with shorter expirations lose value quicker to those of further expirations. However, as this strategy involves selling a put, theta works in favor of the seller of the contract. The writer of the option should consider short term options (typically 45 days). 
• Strike 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. 35-40 Delta strikes are suitable for this strategy.

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Optimal Covered Call and Short Put Reports

OptionsPlay, in partnership with TMX provide investors with daily Optimal Covered Call and Short Put Reports. These reports are designed to save investors time in scanning for income opportunities in the market. Both reports follow the best practices mentioned above and scan hundreds of symbols for optimal income opportunities daily.

The Autofill Trade Link is a new feature added to the Covered Call and Short Put Reports that saves investors even more time! This feature allows investors to seamlessly open a trade on the OptionsPlay platform from the report. Simply click on the link in the report for any trade, and the OptionsPlay platform will instantly open and populate exact details of that trade setup for quicker analysis and execution. By eliminating the inefficiencies of manual input, investors can make quicker trading decisions and immediately analyze important metrics such as probability of profit, Greeks, breakeven, and maximum risk and reward. Additionally, investors can adjust and analyze the trade based on their directional view on the underlying stock and expiration date.

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