SHARE

Generating income is one of the biggest challenges facing investors. Interest rates have been unusually low since the crisis of 2008-2009 nearly brought down the financial system. The Federal Reserve may increase rates this December, but that will do little for anyone who earns a pittance of interest on their bank deposits or bonds.

Yet there is a way to enhance, and even create, an income stream for yourself: stock options.

Most people associate options with risky investments, but that misconception largely reflects the media attention given to speculators. Because options can be used to potentially make a lot of money while putting up only a small amount, some investors make wild-eyed trades because they have heard investment charlatans talk about triple-digit returns.

What is often overlooked, and what is within the grasp of most investors, is using options to create income with conservative strategies. Selling options against stocks that you own, or want to own, is a proven method for enhancing stock returns and reducing risk. The strategy is so simple that most brokerage firms allow people who have never traded options to start with that very approach.

You can think about selling puts and calls as generating a “conditional dividend.” What is the condition? That you are willing to buy or sell the stock if it is below or above the strike price at expiration.

Before we get into the nitty-gritty of this income-generating strategy, it’s important to define our terms. The options industry uses a lot of different words to basically describe the same, or similar, ideas. If you don’t understand the jargon, you will get confused. As we detailed in the first part of this primer (“How to Use Options to Beat the Market,” Oct. 25), everything starts with puts and calls, the building blocks of the options market. A put gives you the right to sell a stock at a certain time and price. A call gives you the right to buy a stock at a certain time and price.

To generate income with options, we don’t buy puts or calls—we sell them. And we’re going to sell them against stocks that we already own, or stocks we want to buy. We will cover some basic concepts to help you determine which route you should take. Afterward, we’ll walk through the various steps to show you how to generate income with options.

Most people buy stocks because they think their price will increase. The natural position of most investors is thus said to be “long.” If they were “short,” they would be betting stock prices are declining, a highly risky strategy. Instead, investors often buy puts to offset the risk that their stocks will decline. If stock prices decline, put prices rise.

This almost always means that put premiums are more expensive than justified. We don’t need to granularly discuss options’ volatility and pricing dynamics, but be aware that persistent demand for puts generally creates a “fear premium” in varying degrees at various times.

Call prices usually do not persistently trade with the same kind of premiums as bearish puts. They can, and do, trade with a “greed premium,” but for the most part calls are reasonably priced. Just as with stocks, most people buy calls because they think stock prices will rise.

Other investors, however, like selling calls to generate income or to monetize higher price targets—and that keeps the call market in a decent state of equilibrium. For whatever reason, fewer investors sell puts. It can be riskier if done improperly, and it usually requires more money upfront—and that makes selling puts an attractive strategy to consider.

Deciding if you will sell calls or puts largely depends on your goals. If you want to potentially buy a stock at a lower price, sell puts. If you want to potentially sell a stock at a higher price, sell calls. Both trades generate income and reduce risk. The amount of income is limited to what you receive for selling the option. The money received also partially hedges the stock.

Now that we have established those bedrock facts, let’s address the jargon.

When you sell calls against stock, it is called a “buy-write,” an “over-write,” or a “covered call.” All three terms basically describe selling a call against a stock position. The buy-write strategy refers to buying stock and simultaneously selling a call. The over-write and covered-call strategies describe selling an option against stock that you already own. (Where does the “write” lingo come from? Before options were electronically traded, brokers wrote out contract specifications on paper contracts.)

When you sell puts against stock, it is called either a “naked put” or a “cash-secured put.” A naked put describes selling a put on a stock that you do not own. (The position is “naked” because the options are not “covered” by stock.) A cash-secured put involves depositing the money, which you would otherwise spend to buy a stock, into a brokerage account and then sell a put. The put is secured by the cash.

Now let’s focus on two strategies that are widely used: selling calls against stocks you own, and selling puts against stocks you want to buy. These are examples of the over-write and the cash-secured put.

The over-write is used by everyone from mutual fund managers to individual investors. It’s popular with money mangers who tend to have price targets on every stock that they buy. In other words, smart investors have already set a sale price when they buy a stock. If they bought a stock at $20, they could have a $30 sale price. In that example, they would systematically sell $30 strike calls against the stock to enhance income—and get paid for owning the stock.

The over-write is such a mainstay strategy that options that expire in three months are often said to form the buy-write market. It is here, three months into the future, that prices are often the best and liquidity often the deepest. Investors will still do just fine at closer expirations, and even more-distant ones, but three months out is a market sweet spot.

The standard income-generation trade is selling options that expire in three months and that have strike prices 5% to 10% higher than the current stock price. Other investors sell calls that expire weekly, reasoning that they can make more money repeatedly selling calls, but that is an approach best left to more seasoned traders.

A good rule of thumb is selling only options that are priced at $1 or more. It is also important to understand that you may miss out on a big rally if you sell calls against a stock. This is the principal drawback to the strategy. In the market, anyone who has a hot stock called away from them is said to experience “upside regret.” (There are ways to mitigate that regret, but that’s a discussion for another day.)

Let’s use Alibaba Group Holding (ticker: BABA), the Chinese Internet retailer, as an example of how an investor might over-write a stock position to generate income. When you sell a call, you are telegraphing to other investors that you think the stock is not likely to advance. If it does advance, you are willing to sell at the strike price. In other words: Don’t sell calls on stocks you are not willing to sell.

In late October 2016, when Alibaba was at $103.94, an investor could sell the January $110 call that expires in 2017 for $3.75 or the January $115 call that expires in 2017 for $2.31. Both premiums are attractive, so how do you pick?

If you are confident the stock will not rise above $110 by January, or you are willing to sell at an effective price of $113.75 (strike price plus the premium received for selling the call), pick the January $110 call. If you want to put more space between the stock and strike price, sell the January $115 call. If the stock never advances above the strike, the money received for selling the call can be kept. If the stock surges, you must sell the stock or cover the call—that is, buy it back—at a higher price.

When you sell a call, you are essentially saying that you do not think a stock price will rise above the call strike price. In other words, you think the associated stock is stalled and unlikely to advance. Sometimes this works out beautifully, and you simply pocket the money that you received for selling the call and collect a nice income.

But sometimes the unexpected happens—and this is why you should never sell call options on stocks you are not willing to sell. Sometimes the stock that you thought was stalled rallies higher. If this happens, you have two choices. You can simply let the stock be “called away” at the strike price, or you can buy back the call. If you buy back the call, the value will have increased, perhaps dramatically, because the call is suddenly “in the money,” that is, valuable and in demand.

The options premium, to be clear, represents the income. Because each options contract represents 100 shares of stock, multiply the call premium by 100. So the $3.75 premium received for the January 115 call is actually $375.

Whenever you trade options—and this applies equally to puts and calls—you must take time to understand what stock-centric events are covered by the expiration date.

Events move stocks. Events represent risk. Events represent opportunity. You must have a view of how a stock might respond to those events before trading options. After all, options do not exist in their own world. They are derivatives, and they derive their value and life from the associated stocks, their sectors, and the broad market.

Alibaba’s January 2017 expiration, for example, covers its earnings on Nov. 2, its Singles Day global shopping extravaganza on Nov. 11, and the lead-up to its late-January earnings. The choice thus becomes deciding if the premiums, which are substantial, are meaningful enough at a time when several events could cause the stock to rally. If the stock price rallies through the strike price, you are faced with selling the stock—and missing out on what could be a substantial rally—or buying back the call at a higher price.

You may have bought into Alibaba at a sharply lower price, and having the stock called away might be just fine. The answer is ultimately personal. Always remember that options trades are the sum of many parts.

Now, let’s flip this whole equation around. There’s nothing wrong with selling calls. It’s probably how most investors get their feet wet in the options market, but selling puts is one of the greatest strategies in existence—provided you remain properly disciplined, and capitalized.

If you were to quiz investors who regularly use options, you’d find that most routinely sell puts. Why? Selling puts lets investors monetize the fear of other investors. It is such a seductive strategy that many pension funds and major institutional investors routinely sell puts to generate income. The risk—which can be managed—is that you must be willing to buy the associated stock if the price drops below the strike price. If you sell a put with a $30 strike price, and the stock falls to $10, you must buy the stock at $30 or cover the put—that is, buy it back at top dollar.

When you sell a put, you are essentially saying that you do not think a stock price will decline. In fact, some strategists believe that selling puts is the single most bullish options trade that exists. Why? Because you only sell puts when you think a stock will rally, or if you are willing to buy the stock if it declines below the put’s strike price.

Sometimes this works out beautifully, and you simply pocket the money that you received for selling the put and collect a nice income. But sometimes the unexpected happens—and this is why you should never sell put options on stocks you are not willing to buy. Sometimes, the stock that you thought was ready to rocket higher actually rockets lower. If this happens, you have two choices: You can simply let the stock be “put to you” at the strike price, or you can buy back the put. If you buy back the put, the value will have increased, perhaps dramatically, because the put is suddenly in the money.

For this reason, many investors incorrectly think that selling puts is incredibly risky. They are not entirely incorrect, but they are glossing over a nuanced subject. If you sell “naked puts”—puts not covered by a stock—you are indeed taking on a great deal of risk.

Just consider the previous example. If the stock sinks, you will be on the hook for a lot of money to cover the put. This is what’s called “downside regret,” and you will feel like the world is collapsing upon you. Somehow, it seems the entire market knows when you are short, and it seems that everyone rises up to make life extra-difficult. The way to get around this is simple: Make sure you have enough money in your brokerage account to actually buy the stock, which is the definition of a cash-secured put.

This cash-secured put strategy works well on stocks that investors want to buy on pullbacks. Many investors sell puts that expire in three months or less with prices that are 5% to 10% below the associated stock’s price.

Back to Alibaba. Let’s say that you’ve watched in wonder as the stock has defied an army of skeptics, rising some 28% this year through Oct. 31, about four times higher than the Standard & Poor’s 500 index. You’ve done your research and you have a good sense of the events that are packed into the January expiration.

With Alibaba’s stock trading just below a 52-week high of $109.87, you are a little concerned about potentially paying top price. What if Alibaba’s earnings aren’t that great, and the stock declines? What if China releases bad economic data and the stock plummets? To reshape that risk, and potentially pocket some added income, you can sell cash-secured puts.

When the stock was around $103.80, Alibaba’s January $95 put that expires in 2017 was bid around $2.78, and the January $97.50 put that expires in 2017 was bid around $3.55. If the stock keeps advancing, you can keep the put premiums.

Ideally, the stock is just below the put strike price at expiration, and then rockets higher. That would allow you to buy the stock at an effective price of $92.22 if you sold the $95 strike.

The key risk to selling puts—and you should keep this thought running in a loop in your brain—is that the stock falls far below the put strike price. But this is the magic of the cash-secured put write. The risk is actually identical to buying stock. As expiration approaches, the loss on an in-the-money put increases dollar-for-dollar with the decline in the underlying shares. What else declines dollar-for-dollar with a drop in the underlying issue? A long position in the underlying stock does. Thus, the downside is the same.

You might think that selling puts and calls to generate income is esoteric. If you regularly sell puts and calls for that purpose, you might even be a little annoyed that one of Wall Street’s great secrets is getting this kind of attention. But the fact is that one day it is likely that no investor will ever buy a stock without first selling a put, or sell a stock without also selling a call.

In May 2016, Morningstar, which millions of individuals rely on to evaluate mutual funds, created a category for options-trading funds that consistently sell puts and calls as part of their main strategy. The classification essentially represents a Good Housekeeping Seal of approval on the income-generation strategy, which should help it gain even broader approval.

In addition, many mutual funds are changing their investment charters so that their managers can use options to reshape risk and generate income. Pension funds are also increasingly using options. Since the financial crisis, some of those massive funds have fired stock managers and instead invested in funds that sell puts and calls. Meanwhile, two of the world’s largest financial firms, Goldman Sachs Group (GS) andBlackRock (BLK), have started telling their clients that options should be considered assets just like stocks and bond.

What is the strategy both of those firms recommend? Selling puts and calls.