Income strategies involve selling options against stock positions. Here’s a video introduction:
The first income strategy involves going long stock and short a call options contract, known as a covered call. For example:
Long 100 shares of ABC stock @ $54
Short 1 ABC Jan 55 call @ $4
Income strategies are typically utilized in flat markets. If you bought ABC shares at $54 but found the stock price didn’t move much, you could sell a call option against the stock. The short call introduces a ‘pro’ and a ‘con.’ The pro - the option’s premium provides the investor added income. The con - the option limits the stock’s upside potential.
If ABC’s market price rises above $55, the call goes “in the money” (gains intrinsic value) and eventually will be exercised (“call up”). Short calls obligate writers to sell stock at the strike price, typically subjecting investors to unlimited risk. If the investor does not own the shares, they must be obtained in the market at an elevated price. There’s no need to do that here! Instead, the investor simply hands over the shares they already own. Therefore, the short call’s risk is “covered.”
If ABC’s market price remains flat or falls, the investor keeps their option premium with no action taken. The option remains unexercised, leaving the $400 premium as a gain. The investor doesn’t want the shares to decline too far, though. The further the market price falls, the bigger the loss on the stock position.
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 bet on a relatively flat market, but that’s different from what happened here. The market price increased to $70, and the call went “in the money” (gained intrinsic value). Option writers want to avoid this because it forces them to fulfill their obligations. In this case, the investor is forced to sell the ABC shares at $55.
When the market price rises significantly, covered call investors experience opportunity cost. If they hadn’t sold the call, they would’ve made a profit of $1,600 (bought 100 shares at $54, valued at $70). By selling the call, they limited their upside gain potential and missed out on stock profits above $55.
The previous example exposes the risk the short call presents to the strategy. The option prevents the investor from making additional returns above the strike price. Opportunity cost does not result in the investor losing money; instead, the opportunity to make a larger return is lost. Because an investor doesn’t introduce more loss potential with the short call (only lost opportunity), covered calls are generally considered safe options strategies. In fact, the call’s premium reduces the investor’s overall risk potential (stock losses are offset by the amount of the premium).
As we discussed previously, income strategies are best for flat markets. Let’s examine what happens when market prices don’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. No money is made or lost on the shares, but the investor keeps the option premium.
If the investor didn’t sell the call, they would have no return (or loss) on the shares. This example illustrates the benefits of an income strategy in a flat market. Even if their shares aren’t making any money, the investor can still make a return on the call’s premium.
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. While the stock loses $4 per share ($400 overall), the premium received from the call offsets those losses.
Even if the market falls a little, the investor can still break even because of the option premium received. For the investor to end up with a loss, the shares must lose more than the premium received from the option.
For our last covered call example, let’s look at the result of 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 loss x 100 shares), but the investor keeps the option premium.
While the option is not meant to be a hedge, it acts as a partial hedge. The investor would’ve lost $2,400 overall if the call didn’t exist. The option’s premium “softens the blow” and reduces the overall loss to $2,000. Regardless, it’s still not a good situation for the investor.
Watch this video if you need additional support on covered calls:
The other income strategy involves going short stock and short a put options contract, known as 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 utilized in flat markets. If you were to sell short 100 XYZ shares at $32 but found that the stock price didn’t move much, you could sell a put to make extra income. If XYZ’s market price falls below $30, the put goes “in the money” (gains intrinsic value) and eventually will be exercised (“put down”). If you recall, short puts obligate their investors to buy the stock at the strike price.
Short stock positions can be used to cover short put contracts. Normally, short puts present substantial risk as they obligate purchasing shares at the strike price. If the stock price falls to $0, a short 30 put would require a purchase of worthless shares at $30. Worthless shares are impossible to sell for any value, resulting in a $30 per share loss. This does not occur with a covered put, as the investor locked in their (short) sale price of $32. Because the stock has already been sold (via the short sale), the investor is no longer concerned with buying worthless shares. This type of strategy is known as 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 bet on the market remaining relatively flat, but that’s not what happened here. XYZ’s market price fell to $10, and the put went “in the money” (gained intrinsic value). Option writers want to avoid this because it forces them to fulfill their obligations. In this case, the investor must buy the XYZ shares at $30 (closing the short stock position).
When the market price falls significantly, covered put investors experience opportunity cost. If they hadn’t sold the put, they would’ve made a profit of $2,200 (sold short 100 shares at $32, buy back cost at $10). By selling the put, they limited their downside gain potential and missed out on stock profits below $30.
The last paragraph demonstrates the opportunity cost related to selling the put contract. In return for a premium, the option prevents the investor from making additional returns below the strike price. Opportunity cost does not result in the investor losing money, only the opportunity to make more.
As we discussed previously, income strategies are best for flat markets. Let’s take a look at what happens if the market remains 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 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 do not make or lose any money, but the investor keeps the $300 premium.
If the investor didn’t sell the put, they would have no return (or loss) on the shares. This example illustrates the benefits of an income strategy in a non-moving market. Even if the short shares aren’t making any money, the investor can still make a return by selling a put.
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 shares lose $300, but the option premium offsets the loss on the shares.
Even if the market rises slightly, the investor can still break even because of the option premium received. This is one of the benefits of an income strategy. The stock position must lose more than the premium received from the option for this strategy to result in an overall 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 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 shares subject the investor to heavy losses, but the option premium slightly reduces the investor’s pain.
While the option is not meant to be a hedge, it acts as a partial hedge. If the put didn’t exist, the investor would’ve lost $6,800 (sold short 100 shares at $32, buy back cost at $100). The option’s premium “softens the blow” and reduces the losses realized as the market price rises. Regardless, it’s still a terrible situation for the investor - the further XYZ’s market price increases, the bigger the overall loss. Therefore, the maximum loss of a covered put is unlimited.
Be careful with the language used here! Although the word ‘covered’ means little or no risk, the put’s risk is covered, not the risk of the short shares. The shares still have unlimited risk potential unless there’s a true hedge (e.g., a long call).
Watch this video if you need additional support on covered puts:
Sign up for free to take 11 quiz questions on this topic