One strategy for earning income with derivatives is selling (also known as "writing") options to collect premium amounts. Options often expire worthless, allowing the option seller to keep the entire premium amount. Although there is a decent opportunity for profit, selling options can entail a substantial amount of risk. Derivatives are financial contracts whose value is derived from underlying assets. Options, along with futures contracts and forward contracts, are some of the most common types of derivatives.
Writing Options Basics
An option on a stock or exchange-traded fund (ETF) is a financial contract granting the buyer the right to purchase 100 shares of the underlying security at a certain strike price until the option’s expiration date. The option buyer is not required to exercise the option. The seller of the option is collecting a premium as compensation for the obligation to deliver the shares to the option holder if the option is exercised. By selling options, an investor can collect premium amounts as an income stream.
Premium income originates from selling risk protection to some buyer seeking risk protection using options contracts. Investors can write options for premium income through several strategies that reduce their overall exposure from selling risk protection, including using spreads, covered calls, or investing in option income funds.
There are many different option selling strategies. One options strategy is selling covered calls. An investor who owns shares of a stock can sell call options with a strike price above the current trading price to collect the premium.
If the option expires in the money, there is a likelihood the investor will need to deliver the shares to the option holder. If the price of the stock stays below the strike price until the option’s expiration date, the investor gets to keep the entire amount of the premium. This is a strategy with limited risk since the investor owns the shares of the underlying stock.
Selling naked options is another strategy that has unlimited risk. An investor sells options with no position in the underlying security and no other option to hedge the risk. If the option expires worthless, the investor gets to keep the entire premium amount. However, if the price goes against the sold option, losses can be substantial.
Options Income Funds
An option income fund, also known as an option income closed-end fund (CEF), is a type of pooled investment whose goal is to generate current income for its investors by earning premiums from selling options contracts. This can be done by selling delta-neutral options strategies such as straddles or strangles, or by writing covered calls, among other more complex strategies.
The Bottom Line
Selling options can generate steady income flows for investors, but there are also unique risks, especially with selling naked options, that should be evaluated before engaging in any strategy.
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