One of the most popular stock income strategies is a “covered call.”
In this strategy, you own some stock. So you sell a call option to generate income.
If that option expires worthless, you keep your shares… and the premium you earned.
You can then repeat that process and sell another call option for more income – multiple times over.
Over time, your profits can add up. (That’s especially true if you’re earning dividends from holding your stock!)
As with most options strategies, though, there are variations on the theme…
Today, I want to share a variation with an additional income stream…
The Right Balance
Let’s first start with an example of a covered call…
You own 100 shares of a stock trading at $100.
If you sold your call option with a $100 strike price, you’d likely receive a big premium.
But there’s a high chance the option would get exercised… and you’d have to sell your shares.
So usually you want to sell your call option at a higher strike than the current share price. That way, you give the trade some room…
The trade-off is less chance of being exercised in exchange for a lower premium. The sweet spot is to find a balance between the two factors.
So let’s go back to our example…
You decide to write your call option at $120. You receive $5 of premium per share. (This is $500 in income since each option covers 100 shares.)
If the stock is trading above $120 at expiry and the option is exercised, you have to hand over your shares at $120.
But if the stock is trading below $120, you get to keep the premium and your shares.
And there’s another leg we can add to the trade to generate even more income…
Adding Another Leg
Let’s return to our example with shares trading at $100.
You are also happy to buy more shares if the stock falls to $80.
That’s where the next leg of this trade fits into the picture.
You can also sell a put option with a strike price of $80.
If shares fall to $80 (or below) and the option gets exercised, you’re obligated to buy 100 shares per contract at $80 per share.
But you also receive $5 for writing your put option. (Again, this is $500 of income since an option covers 100 shares.)
You’ve now collected a total of $1,000 in premium from selling the call and put options.
If the stock rallies above $120, you must hand over your 100 shares at $120. And if the stock falls below $80, you must buy 100 shares at $80.
But if the shares are trading between $80 and $120 at expiry, you get to keep your shares… and the $1,000 of income you earned.
And you can now apply the strategy again and again.
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The Right Application
This strategy is known as a “strangle.” (Specifically, it’s a “short strangle” since we’re selling the options rather than buying.)
And you use this strategy when you are neutral about a stock.
Ideally, both options will expire worthless and you can keep all the premium… and then potentially sell a second round of options for more income.
But you’re also happy to sell your shares if the stock rallies some… In our example, you’re okay with selling your shares at $120 if the stock rises.
You’re also happy to grow your position size if the stock falls some. In our example, you’re okay with buying 100 more shares if the stock falls to $80.
But you wouldn’t apply this strategy if you thought the stock would explode higher or lower.
After all, you’d be frustrated to sell your shares at $120 if it’s trading at $140. And you’d be upset if you had to buy shares at $80 if the stock has fallen to $60.
So there’s a middle ground you’re aiming for.
Yet in the right setup, a strangle can be a potent source of income… especially if you’re expecting the stock to trade sideways.
That makes this another great options strategy to have in your toolbelt as a trader.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict
P.S. Is there an options strategy you want to hear more about? Write to me at [email protected].