Income strategies involve selling options against stock positions. Here’s a video introduction:
The first income strategy combines long stock with a short call options contract. This position is called a covered call because the investor already owns the shares that may need to be delivered if the call is exercised.
For example:
Long 100 shares of ABC stock @ $54
Short 1 ABC Jan 55 call @ $4
Income strategies are typically used in relatively flat markets. If you bought ABC shares at $54 and the stock price doesn’t move much, you can sell a call option against the stock to generate income.
Selling the call creates a trade-off:
If ABC’s market price rises above $55, the call goes in the money (it gains intrinsic value) and may be exercised (the investor is “called up”). A short call obligates the writer to sell shares at the strike price. Normally, a short call can create unlimited risk because the stock price can rise without limit.
That unlimited-risk problem occurs when the call writer doesn’t own the shares and must buy them in the market at a higher price to deliver them. In a covered call, the investor already owns the shares, so they can deliver those shares if assigned. That’s why the short call’s risk is considered “covered.”
If ABC’s market price stays flat or falls, the call remains out of the money and typically expires worthless. The investor keeps the premium (here, $4 × 100 = $400). The main remaining risk is the stock itself: if the shares fall far enough, the stock loss can outweigh the premium received.
Let’s look at a few examples:
An investor buys 100 shares of ABC stock at $54 and goes short 1 ABC Jan 55 call at $4. What is the gain or loss if ABC’s market price rises to $70?
Can you figure it out?
Answer = $500 gain
| Action | Result |
|---|---|
| Buy shares | -$5,400 |
| Sell call | +$400 |
| Assigned - sell shares | +$5,500 |
| Total | +$500 |
Income strategies assume a relatively flat market, but here the stock rose sharply to $70. That makes the call in the money, and the investor is assigned. The investor must sell the shares at $55, even though the market price is higher.
This is where opportunity cost shows up. If the investor hadn’t sold the call, the stock profit would have been $1,600 (buy at $54, value at $70, on 100 shares). By selling the call, the investor capped the stock’s upside above $55 and gave up the additional profit from $55 to $70.
This example highlights the main drawback of the covered call: the short call prevents additional gains above the strike price. Notice that this opportunity cost doesn’t create an actual loss in dollars in this scenario - the investor still made money - but it does reduce what the investor could have earned.
Because the short call doesn’t add extra downside risk beyond owning the stock (it mainly limits upside), covered calls are generally considered relatively safe options strategies. The call premium also reduces overall downside exposure by offsetting stock losses dollar-for-dollar up to the amount of the premium.
As discussed earlier, income strategies work best when market prices don’t move much.
An investor buys 100 shares of ABC stock at $54 and goes short 1 ABC Jan 55 call at $4. What is the gain or loss if ABC’s market price stays flat at $54?
Answer = $400 gain
| Action | Result |
|---|---|
| Buy shares | -$5,400 |
| Sell call | +$400 |
| Value of shares | +$5,400 |
| Total | +$400 |
The call stays out of the money and expires worthless. The shares don’t change in value, so the investor’s profit comes entirely from keeping the option premium.
Without the call sale, the investor would have no gain (and no loss) on the shares. This is the core benefit of an income strategy in a flat market: the option premium can create a return even when the stock doesn’t move.
What happens if ABC’s market price falls by a small amount?
An investor buys 100 shares of ABC stock at $54 and goes short 1 ABC Jan 55 call at $4. What is the gain or loss if ABC’s market price falls to $50?
Answer = $0 (breakeven)
| Action | Result |
|---|---|
| Buy shares | -$5,400 |
| Sell call | +$400 |
| Value of shares | +$5,000 |
| Total | $0 |
The call stays out of the money and expires worthless. The stock loses $4 per share ($400 total), and the $400 premium offsets that loss.
This shows how the premium provides a cushion. The investor doesn’t have an overall loss unless the stock drops by more than the premium received.
For our last covered call example, consider a significant market downturn.
An investor buys 100 shares of ABC stock at $54 and goes short 1 ABC Jan 55 call at $4. What is the gain or loss if ABC’s market price falls to $30?
Answer = $2,000 loss
| Action | Result |
|---|---|
| Buy shares | -$5,400 |
| Sell call | +$400 |
| Value of shares | +$3,000 |
| Total | -$2,000 |
The call stays out of the money and expires worthless. The shares lose $2,400 of value ($24 × 100), but the investor keeps the $400 premium.
The option isn’t designed as a hedge, but it does act as a partial hedge. Without the call, the investor would have lost $2,400. The premium reduces the loss to $2,000.
Watch this video if you need additional support on covered calls:
The other income strategy combines short stock with a short put options contract. This position is called a covered put because the short stock position can be used to cover the obligation created by the short put.
For example:
Sell short 100 shares of XYZ stock @ $32
Short 1 XYZ Jan 30 put @ $3
As you already know, income strategies are used in flat markets. If you sell short 100 shares of XYZ at $32 and the stock price doesn’t move much, you can sell a put to generate extra income.
If XYZ’s market price falls below $30, the put goes in the money (it gains intrinsic value) and may be exercised (the investor is “put down”). A short put obligates the writer to buy shares at the strike price.
Normally, short puts can create substantial risk. If the stock falls to $0, a short 30 put would still require buying shares at $30, creating a $30 per share loss on worthless stock.
That specific risk is different in a covered put because the investor already sold the shares short at $32. Since the sale price is locked in by the short stock position, the investor is no longer concerned about being forced to buy “worthless” shares at $30 and then being unable to sell them for value. The short stock position is what makes this a covered put.
Let’s go through a few examples to understand this strategy better:
An investor sells short 100 shares of XYZ stock at $32 and goes short 1 XYZ Jan 30 put at $3. What is the gain or loss if XYZ’s market price falls to $10?
Answer = $500 gain
| Action | Result |
|---|---|
| Sell short shares | +$3,200 |
| Sell put | +$300 |
| Assigned - buy back shares | -$3,000 |
| Total | +$500 |
Income strategies assume a relatively flat market, but here the stock fell sharply to $10. That makes the put in the money, and the investor is assigned. The investor must buy the shares at $30, which closes the short stock position.
This is another example of opportunity cost. If the investor hadn’t sold the put, the short stock profit would have been $2,200 (sell at $32, buy back at $10, on 100 shares). By selling the put, the investor limited the downside profit below $30.
The key idea is the same as with covered calls: in return for the premium, the option limits how much the investor can profit once the stock moves beyond the strike price.
As discussed earlier, income strategies are best for flat markets.
An investor sells short 100 shares of XYZ stock at $32 and goes short 1 XYZ Jan 30 put at $3. What is the gain or loss if XYZ’s market price stays at $32?
Answer = $300 gain
| Action | Result |
|---|---|
| Sell short shares | +$3,200 |
| Sell put | +$300 |
| Buy back cost | -$3,200 |
| Total | +$300 |
The put is out of the money and expires worthless. The shares don’t gain or lose value, so the investor keeps the $300 premium.
Without selling the put, the investor would have no gain (and no loss) on the short shares. This shows how an income strategy can generate a return even when the stock doesn’t move.
What happens if the market rises by a small amount?
An investor sells short 100 shares of XYZ stock at $32 and goes short 1 XYZ Jan 30 put at $3. What is the gain or loss if XYZ’s market price rises to $35?
Answer = $0 (breakeven)
| Action | Result |
|---|---|
| Sell short shares | +$3,200 |
| Sell put | +$300 |
| Buy back cost | -$3,500 |
| Total | $0 |
The put is out of the money and expires worthless. The short shares lose $300, but the $300 premium offsets that loss.
As long as the stock’s loss on the short shares is no more than the premium received, the position can still break even.
What happens if the market rises significantly?
An investor sells short 100 shares of XYZ stock at $32 and goes short 1 XYZ Jan 30 put at $3. What is the gain or loss if XYZ’s market price rises to $100?
Answer = $6,500 loss
| Action | Result |
|---|---|
| Sell short shares | +$3,200 |
| Sell put | +$300 |
| Buy back cost | -$10,000 |
| Total | -$6,500 |
The put is out of the money and expires worthless. The short shares create large losses, and the option premium only reduces those losses slightly.
The option isn’t designed as a hedge, but it does act as a partial hedge. Without the put, the investor would have lost $6,800 (sell at $32, buy back at $100, on 100 shares). The $300 premium reduces the loss to $6,500.
It’s important to be precise with the word covered here. The put’s risk is covered, not the risk of the short shares. The short stock position still has unlimited loss potential unless there’s a true hedge (e.g., a long call). Therefore, the maximum loss of a covered put is unlimited.
Watch this video if you need additional support on covered puts:
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