How to use Options as an Income Generation Strategy?
Options trading is one of the most powerful techniques that provide an opportunity for an investor to create wealth. Investors seeking to generate income from equity portfolios on a regular basis can employ option writing strategies using puts and calls to buy and sell stocks. In addition to producing income, writing puts to buy stocks lowers the cost basis of the purchase.
What Is Option Trading?
Options act as insurance by transferring the risk of the options buyers to the sellers of an option against the option premium amount. The buyer of the options can hedge its risk on the underlying asset, while the seller gets the benefit of the option premium. Options are contracts that give the holder the right but not an obligation to buy or sell an amount of some underlying asset at a predetermined price at or before the contract expires. An option contract covers 100 shares of the underlying stock and includes a strike price and an expiration month. Options are derivatives as they derived their value from the underlying assets. There are two types of options: call option and put option.
Call Option Trading
When an investor expects the stock of a company will move upward in the future, he may buy the call option that gives him the right but not an obligation to buy the 100 shares of the underlying stock at the strike price at or before the expiration of the contract. He pays a premium amount to the option writer(seller) for buying the right. On the expiration date, if the current market price of the stock is greater than the strike price of the call option, the buyer of the call will exercise its option. The seller of the option must sell the share at the strike price because it is his obligation. The buyer of the call gets the benefit of buying the shares at a lower price while the seller of the option enjoys the premium amount. If the option expires while the share price is above the strike price the option writer keeps the premium and can sell another put option to generate additional income.
Example of a Call Option Strategy:
Suppose the spot price of the XYZ company is $75 an investor expects it to rise to $80 at the end of the month, he can purchase the call option of 100 shares at a premium of $2. He will generate profit if the spot price of the share increases to $82(Break-even Point). If the spot price remains below $80, the buyer doesn’t exercise its right and bear the loss of $2(premium). This is referred to as “Out of the money” and the value of the call becomes zero. The maximum loss of the buyer of the contract is limited up to the premium amount while the profit on the shares is unlimited.
Put Option Trading
When an investor expects the price of the shares of a company will move down, he may buy a put option that gives him the right but not an obligation to sell his shares at the predetermined price(strike price). The buyer of the put option gets the right to sell the shares of an underlying stock at the strike price by paying a premium to the writer. If the spot price of the shares is lower than the strike price of the contract, the put buyer will exercise its right and sell the shares of an underlying stock at the higher price(strike price). The seller of the put has obligated to purchase the shares if the buyer wants to exercise its right. If the strike price of the contract is lower than the spot price, the buyer may not intend to sell the shares at a lower rate in this case he doesn’t exercise its right. The seller of the put gets the benefit of the premium amount.
Example of a Put Option Strategy:
Suppose the spot price of the XYZ company is $75 an investor expects it to drop at the end of the month, he can purchase the put option of 100 shares at a strike price of $65 at the premium of $3. He will generate profit if the spot price of the share reduces to below $67(Break-even Point). If the spot price remains higher than $80, the buyer doesn’t exercise its right and bear the loss of $3(premium). This is referred to as “Out of the money” and the value of the put becomes zero. Option holders will exercise the option only when their position is “In the money”.
Position of the Put holder at different spot prices:
Combine Options and other Strategies to gain maximum profit
Call and put strategies help an investor to minimize their losses and generate unlimited profits. 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.
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