Income strategies involve selling options against stock positions. Here’s a video introduction:
A common income strategy is to go long stock and short a call options contract. This is called a covered call, also known as a buy-write strategy. For example:
Long 100 shares of ABC stock @ $54
Short 1 ABC Jan 55 call @ $4
Income strategies are typically used when you expect a relatively flat market. If you bought ABC shares at $54 and the stock price doesn’t move much, you can sell a call option against the stock.
Selling the call creates a clear 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 call is “called up”). A short call obligates the writer to sell shares at the strike price.
Normally, a short call can create very large risk because the stock price can rise without limit. If you don’t own the shares, you’d have to buy them in the market at the higher price to deliver them. With a covered call, you already own the shares, so you can deliver the shares you hold. 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 unexercised. In that case, you keep the premium (here, $4 × 100 = $400). Keep in mind, though: the stock can still lose value. The further the stock falls, the larger the loss on the shares.
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 puts the call in the money, and the investor is assigned. Assignment forces the investor to sell the shares at the strike price ($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 position would be worth a $1,600 profit (buy at $54, value at $70, on 100 shares). By selling the call, the investor gave up any stock gains above $55.
This example highlights the main drawback of the covered call: the short call caps the upside. Notice that this doesn’t create an additional loss beyond what the stock can already do - it mainly creates lost upside.
Because the short call doesn’t add downside risk to the stock position (it only limits upside), covered calls are often considered relatively conservative. Also, the call premium reduces net stock losses by the amount of premium received.
As discussed earlier, income strategies tend to work best in flat markets. Here’s what happens when the stock price doesn’t move.
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 neither gain nor lose value, and the investor keeps the option premium.
Without the call sale, the investor would have no gain (and no loss) on the shares. This is the core idea behind income strategies: even if the stock goes nowhere, the option premium can still produce a return.
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 the “cushion” created by the premium: the stock can fall by up to the premium received before the overall position turns into a net loss.
For our last covered call example, let’s look at 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 in 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 net loss to $2,000.
Watch this video if you need additional support on covered calls:
Another income strategy is to go short stock and short a put options contract. This is called a covered 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 typically used when you expect a relatively flat market. If you sell short 100 XYZ shares 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 put is “put down”). A short put obligates the writer to buy shares at the strike price.
On its own, a short put can create substantial risk. For example, if the stock fell to $0, a short 30 put would still require buying shares at $30, creating a $30-per-share loss.
With a covered put, the short stock position is used to cover the short put obligation. Because the investor already sold the shares short at $32, they’ve effectively locked in that sale price. If assigned on the put, they buy shares at the strike price ($30) to close the short stock position. In that sense, the short stock position “covers” the short 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 ABC’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. Assignment forces the investor to buy 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 position would have produced a $2,200 profit (sell at $32, buy back at $10, on 100 shares). By selling the put, the investor gave up any additional profit below $30.
The key idea is the same as with covered calls: in exchange for premium, the option limits how much the stock position can profit beyond the strike price.
As discussed earlier, income strategies are best for flat markets. Here’s what happens if the market stays neutral.
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 ABC’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 stays out of the money and expires worthless. The short shares neither gain nor lose value, and the investor keeps the $300 premium.
Without selling the put, the investor would have no gain (and no loss) on the short stock position. This is the income-strategy benefit in a flat market.
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 ABC’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 stays out of the money and expires worthless. The short shares lose $300, but the $300 premium offsets that loss.
As with covered calls, the premium provides a cushion. The stock position must lose more than the premium received for the overall strategy to produce a net loss.
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 ABC’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 stays out of the money and expires worthless. The losses come from the short stock position, and the option premium only reduces the loss slightly.
The option isn’t meant to be a hedge, but it acts 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 net loss to $6,500.
Be careful with the word covered here. The put’s risk is covered by the short stock position, but the short stock position itself still has unlimited risk unless there’s a true hedge (e.g., a long call). Therefore, the maximum loss of a covered put is unlimited.
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