Option Income -
What does it mean?
Option Income can essentially be derived from one of the two main strategies - either by selling calls or selling puts, both selling of call an put can be done either naked or covered.
Investors write covered call to generate additional return through the selling of the call options thereby collecting the premium as option income which is paid by the buyer. Under conventional wisdom, writing (selling) covered call is generally considered to be a conservative approach as it involves the ownership of the underlying stocks and selling of call options based upon that ownership.
The reason why covered call is considered to be a safe option strategy simply because, barring the risk that the investor was already willing to take in a stock position, the premium that is being collected actually helps to buffer some potential losses.
Being the seller of the call, you give the buyer the right to buy the stock from you at a predetermined strike price. The seller (in this case, you) of the call option therefore, in the trade-off for collecting the premium as option income, forgone the potential upside profit beyond the strike price.
While there are people who think that selling naked put is dangerous, it actually bear no greater risk than the covered call position. Important Caveat: The preceding statement is true only if no excessive position is being taken, as selling naked put do require less capital outlay, and this situation may be abused by novice traders.
For example, after taking into considerations of your total trading capital and risk capital for each trade, if your intended trade size for a covered call position is 500 shares of XYZ stocks along with selling 5 call options, a corresponding approach will be only to sell 5 put options and no more. In this way, the risk level that you have taken is similar in both scenario.
One point to note here is, for covered call, you will have two round trip commissions to pay versus one round trip commission for selling naked put options.
Following the above discussion, a naked put option is actually quite similar to covered call if one were to look at the resulted risk-reward. The main difference is that you do not own the underlying stock at the onset for selling naked put and are prepared to own the underlying stock.
By selling the naked put, you as the seller have the following intentions:
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To own the stock at a discount from its current price.
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Or, simply satisfied to just collect the premium as option income as the put option expires worthless if the stock price stays beyond the strike price after the expiration date.
The covered call strategy will be for individuals whose preference is to own the underlying stock but want to generate extra income (return) via the writing of call options.
However, should the stock being put (buyer of the put option exercise the option) to the put seller, the put seller has to make a conscious decision and determine whether the <>basic parameters (be it fundamental or technical) that he based his initial trade decision on, remains, improved or worsen to decide whether to continue owning the underlying stocks.
In conclusion, both the above strategies require the price of the underlying to be on the upward trend or at the very least, somewhat stable for the trades to be profitable in creating option income. While the risk-reward profile may be similar, there are some mindset difference between the covered call option sellers and the naked put sellers. Understanding the difference and knowing what works best for you is the way to creating option income successfully for you for many moons to come.
Option Income Funds - Funds that derived returns via the owning of underlying stocks and write the corresponding covered call options.
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