You might already be familiar with buying options. Options are a great way to control risk. That’s because you can’t lose more than the premium paid for the option. You know exactly how much you stand to lose.

Options can also magnify a small change in the underlying stock price to a large gain. It’s a way to get leverage from a small price move.

But there’s another lesser-known way to leverage options to your advantage. And that is by generating income through selling an option contract.

When you sell an options contract, you’re collecting money from the buyer in exchange for agreeing to sell 100 shares of the underlying stock for a certain price before the contract expires.

There is a different set of questions to address when selling a contract.

And when you’re new, you don’t always know how to choose the right strike price.

For example, if you sell a call option with a $50 strike price, you must hand over your shares at $50 per share if the buyer exercises the option before it expires.

That’s true even if the stock is currently trading above $50. You’re locked in at the strike price.

So how do you decide on the right option to sell?

Which Option?

Let’s consider selling a “covered call” to illustrate… (A covered call is when you sell a call option against 100 shares you own to generate income. It’s much safer than selling an option when you don’t already own shares.)

Say the underlying stock is currently trading at $50 per share. If you write an option that is way out-of-the-money (OTM) with a $100 strike price, there is little chance of the buyer deciding to exercise the option. That can be a positive if you want to keep your shares long-term.

But the downside is that you’ll likely generate minimal income. The further you write your call option above the current stock price, the less valuable that option is.

On the other hand, if you write a call option that’s in-the-money (ITM) – that is, the call option’s strike price is below the stock price at $45, for example – you’ll generate far more income.

But in this case, the obvious downside is that you’re likely locked into selling your shares below the market price.

You’d only consider an ITM strategy if you thought the stock was about to have a short-term pullback before the option expires.

So what’s a better solution for earning income?

Find the Right Balance

The best way to sell options for income is to write your call options as close to the money (at-the-money, ATM) as you’re willing to.

For example, if the stock is trading at $50, you might write your call option with a $55 strike price.

But it’s all a matter of finding the right balance between profiting from selling the option while still keeping your shares.

For example, if a stock is trading around $50 and you think the maximum price it will hit within the option’s life is $55, then you’d likely write your calls with a $60 strike price.

As long as the stock is trading below $60 when the option expires, you’ll get to keep the money the option buyer paid you… plus your shares.

And then you can turn around and write a new option against your shares for additional income.

That’s what makes a covered call an excellent income strategy. The trick is to generate the maximum income while finding the best odds against the likelihood of your option being exercised.

Get that balance right, and this income strategy can really work in your favor.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict