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 position is called a covered call because the investor already owns the shares needed to meet the call obligation. 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 shares to generate income.
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 shares are “called away”). A short call obligates the writer to sell shares at the strike price. If the investor didn’t own shares, they might have to buy them in the market at a higher price, which can create large losses. 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 unexercised. The investor keeps the premium (here, $4 × 100 = $400). However, the stock position can still lose value if the shares fall - premium income only offsets losses up to the amount 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. Because the call is in the money, the investor is assigned and must sell the shares at $55.
This is where opportunity cost shows up. Without the short call, the investor would have gained $1,600 on the stock (from $54 to $70, times 100 shares). By selling the call, the investor gave up any stock gains above $55.
This example highlights the main drawback of a covered call: the short call caps the upside. Notice, though, that this is not an additional loss beyond owning the stock - it’s a missed opportunity to earn more.
Because the short call doesn’t add downside risk beyond the stock itself (it mainly limits upside), covered calls are generally considered relatively conservative. The call premium also reduces net stock risk by offsetting losses dollar-for-dollar up to the premium amount.
As discussed earlier, income strategies are best suited to flat markets. Let’s see what happens when the stock 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 don’t change in value, and the investor keeps the $400 premium.
Without selling the call, the investor would have no gain or loss. This is the core benefit of an income strategy in a flat market: the option premium can generate a return even when the stock doesn’t.
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), but 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), and the investor keeps the $400 premium.
The option isn’t designed as a full hedge, but it does act as a partial hedge. Without the call, the loss would have been $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 position is called a covered put because the short stock position can offset 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 with covered calls, covered puts are typically used when you expect a relatively flat market. If you sell short 100 shares of XYZ at $32 and the stock doesn’t move much, you can sell a put to collect premium income.
If XYZ’s market price falls below $30, the put goes in the money (it gains intrinsic value) and may be exercised (the shares are “put” to the writer). A short put obligates the writer to buy shares at the strike price.
Normally, a short put can be very risky because it can force the investor to buy shares at the strike price even if the stock collapses. 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.
In a covered put, the investor already has a short stock position and has effectively locked in a sale price of $32. If assigned on the put, the investor buys shares at $30, which can be used to close the short stock position. Because the investor sold the shares short at $32 and can buy them back at $30 through assignment, the put obligation is “covered” by the short stock.
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. The put is in the money, so the investor is assigned and must buy shares at $30, which closes the short stock position.
This creates opportunity cost. Without the short put, the investor would have profited $2,200 on the short stock (sold at $32, bought back at $10). By selling the put, the investor gave up profits below $30.
The key point is the same as with covered calls: the premium comes with a trade-off. The option limits how much the investor can profit once the stock moves beyond the strike.
As discussed earlier, 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 short shares have no gain or loss, and the investor keeps the $300 premium.
Without selling the put, the investor would have no return. This is the main benefit of the strategy in a flat market: the premium can generate income 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 position is no more than the premium received, the overall 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 the loss slightly.
The option isn’t designed as a full hedge, but it acts as a partial hedge. Without the put, the investor would have lost $6,800 (sold at $32, bought back at $100). The $300 premium reduces the net loss to $6,500.
Be careful with the word covered here. The put obligation is covered, but the short stock position still has unlimited risk unless there’s a true hedge (for example, 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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