Options trading is a good way to add income to your portfolio. Even though it can be complex, this type of investment enables you to earn profit irrespective of the market's direction.
For successful trading, traders need to have a good understanding of the underlying and the strategy they want to use. In this post, we will discuss the best options strategies for income and cover when it is the right time to execute them.
About Options Trading
Before we get into the best options strategies for income, let’s briefly talk about what options trading exactly is.
Options are a type of trading contract that gives the holder of the options the right to buy and sell an asset within a specific time frame. The investor is not obligated to buy or sell, but if he decides to do so, he needs to perform a trade before the expiration date at a predetermined price.
There are two types of options known as calls and puts. The calls give the trader the to buy an asset within a specific time frame, whereas the puts give the trader the right to sell. Your position on the asset plays a huge role in the options trading process.
If you short the stock, you are predicting the value of the asset on the market will decrease in value. On the other hand, if you hold a long position, you anticipate the underlying stock to grow in value.
Options Strategies for Income
Covered Call
This well-known strategy generates income and is used by traders to protect themselves from the risk of being long on the stock. As the name suggests, a covered call is a two-part strategy that involves selling call options.
A covered call is implemented when you sell the right to someone to purchase a stock you already own at a specific price before a specified date. Hence, by owning the stock, you are covered in case the stock rises and the call option expires in the money.
How it works
This is the strategy to use when you have neutral to bullish sentiment about the underlying stock. The covered call is considered a low-risk strategy, as the loss you can experience is limited. It involves two steps, buying shares of stock that aren’t volatile and selling options against the stock you have purchased.
When using a covered call, most investors sell options with an ATM or slightly OTM strike price. Once you sell the option, the buyer has to pay a premium that you keep as an income. Generally, the options involve 100 shares.
Maximum profit and loss
Maximum profit when it comes to the covered call strategy is achieved when the stock price is at or above the call's strike price at the expiration date. Maximum loss is limited to the price paid for the asset minus the option premium you receive.
Protective Collar
As an investor, you use a protective collar when you own a stock, sell a covered call, and buy a protective put.
For a protective collar, the investor writes a call option and sells a put option with the same expiration date to protect a long position in the underlying stock.
How it works
With a protective collar, you can generate income by selling the call option for more than what you paid for the put option. If the stock price remains neutral and the strike price is not met, you can still gain profit regardless of stock movement.
The long put and the short call form ‘collar’ for the underlying stock, which is defined by the strike prices.
Then, the put position provides downside protection for the stock until the expiration date of the put. A protective collar is a strategy for income that comes with limited risk.
Maximum Profit and Loss
The maximum gain of the protective collar is the difference between the stock's current price and the call strike price.
Maximum loss is the difference between the stock's current price and the put strike price. The breakeven equals the stock price and the plus or minus the premium.
Married Put
A married put is a strategy similar to the covered call but still slightly different. A married put is a strategy in which the investor holds a put contract for the stock and shares for the stock.
As you purchase the two positions simultaneously, the trade is said to be ‘married’. By owning both the put and the stock, the investor has protection against price changes.
How it works
The married put strategy works as insurance for the investors. The reason for this is that by buying a put option, you can protect your downside while participating in any upside potential.
This is a bullish strategy to use when you are concerned about the uncertainties of the stock. The strategy has an unlimited profit potential but limited loss, which is why it is on the list of options strategies for income.
Maximum profit and loss
The maximum potential profit of this strategy is limited to the stock’s price minus the premium paid for the option.
On the other hand, the maximum loss regarding a married put is the difference between the price paid for the stock and the strike price of the put option you purchased as insurance.
Strangle Options Strategy
This is an options strategy for income with multiple options contracts. Investors use the strangle option when they expect the underlying asset's direction.
It involves buying a call option with a strike price that is above the current stock price and a put option with a strike price below the current asset price with the same expiration date. There are two types of strangles known as long and short strangles.
How it works
A long strangle is a strategy where both a long call and a long put have different strike prices but have the same expiration date and are purchased simultaneously.
In addition, a short strangle involves the investor selling call and put options at the same time at different market prices but with the same maturity date.
This strategy allows the investors to profit from their guesses about the changes in stock prices. Like other options strategies for income, the strangle enables the investors to gain additional income from their holdings and leverage their portfolio.
Maximum profit and loss
The potential profit for the strangle is unlimited and generates profit when the asset moves in price. The potential losses of this strategy are limited to the net debit paid.
Straddle Option
This neutral options strategy involves buying and selling a put option and a call option on the same underlying asset, strike price, and the same expiration date.
This is a strategy to use when you expect a significant move in the asset’s price but are unsure which direction it will move.
How it works
There are two types of straddle: long and short straddle strategy. In the long straddle, the investor buys the call and the put options with the same strike price and expiry date.
The long straddle is considered a low-risk strategy as the cost of buying the options is the maximum amount of loss you can face.
On the other hand, the short straddle involves selling call and put options with the same strike price and expiry date.
In comparison to the long straddle, this is a riskier strategy as the investors can lose the total value of the stock, and the profit is limited to the premium.
Maximum profit and loss
The maximum profit for the long straddle is unlimited and based on the price of the underlying asset. The higher the price rises, the higher the potential profit is.
Maximum loss happens when the strike price is equal to the spot price of the underlying asset at the expiration date.
When it comes to short straddles, maximum profit is earned when the stock price closes at the strike price, and both options expire worthless. When the stock goes down, the losses are limited to the strike price minus the net credit you received for selling the straddle.
Iron Condor
This well-known strategy works best when you expect low volatility in the market. It is a strategy constructed from four contracts - two short and two long positions. For this options strategy, you buy a call and a put option and sell a call and a put option.
How it works
You make money with iron condor through the premiums you earn by selling the call and the put. When the strike price is not hit, the contracts expire, and you gain income from the premiums.
This is an options trading strategy that involves two vertical spreads. The strategy involves two positions- long and short condors. Long condor is used when the trader expects low volatility on the market, whereas short condor is when the trader expects high volatility on the underlying asset.
Maximum profit and loss
The iron condor is a strategy that earns a maximum profit when the underlying asset closes between the middle strike prices at their expiration.
The maximum loss in terms of the iron condor is the difference between the long and short call strikes or the long and short put strikes.
Iron Butterfly
Similar to the iron condor, the iron butterfly is a strategy to use when you expect low volatility. It features four contracts and involves a long call and put and a short call and put. The main difference between the iron butterfly and the iron condor is that the short contracts are sold at the same price.
How it works
In iron butterfly, the goal is to take advantage of the little to no movement from the underlying asset. This is a strategy to initiate when you expect the stock price to stay range-bound before expiration.
The iron butterfly strategy is an advanced strategy that involves buying one OTM put, selling an ATM put and selling the ATM call, and buying the OTM call. The strategy has the potential for high earnings, so the main goal of using this strategy is to earn income.
Maximum profit and loss
You gain maximum profit for the iron butterfly strategy when the price of the underlying stock at expiration equals the strike price at which you have sold the call and the put options.
On the other hand, maximum loss for iron butterfly happens once the price of the underlying stock either falls below the lower strike of the put you purchased, rises above, or to the higher strike of the call you have purchased.
How to Be Successful in Options Trading
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Conclusion
Options trading requires extensive knowledge, experience, and trading skills. As a successful trader, you need to implement the right strategy, analyze the market, and manage the risk.
Options trading allows the trader to earn a lot of profit and only risk the money they paid for the premium.
In this article, we have covered the best options strategies for income that can help you reach your financial goals.