Interest rates are at historically low levels, creating investor appetite for income producing strategies.
Below I present three option strategies that seek to generate income from stock positions.
Covered calls
The strategy consists of selling a call option against a stock position. The option is sold for an upfront premium.
The option buyer acquires the right to purchase the stock at a pre-set price (the strike). The right must be exercised by a pre-set date (the expiration date).
The contract expires worthless if it is not exercised.
The call is exercised when the stock price has risen above the strike by the expiration date. When exercised, the investor sells the stock and receives the strike price.
The strategy caps the upside from holding the stock to the level of the strike. The investor has unprotected downside below the option strike when the stock price decreases.
Volatile stocks generate higher premiums. A four-month option struck at the recent market price for Snap Inc. (SNAP) commanded a 15% premium. A similar expiration call option for shares of Tesla (TSLA) had an 18% premium.
Collars
Collars consist of a covered call combined with a lower strike put. Both options have the same expiration date. Adding the put prevents losses if the stock price drops below the low strike.
The strategy generates less premium than a covered call because the cost of the put option subtracts from the premium of the covered call.
If the stock price drops below the put strike, the investor can exercise the put. Shares are delivered in this scenario and an amount equal to the put strike is received in exchange.
For example, three-month Exxon Mobil Corporation (XOM) call options struck at the money recently had a 10% premium. A put struck 15% below the call strike had a 4% premium.
A collar using the two options would generate a net premium of 6%.
The maximum loss for the investor was 15%. The maximum payout is the high strike.
Covered call spreads
The strategy combines selling a covered call with the purchase of a higher strike call. Both options have the same expiration date.
Because the option being purchased has a higher strike than the option that is sold, the net premium is positive.
The investor receives income from the net premium, and benefits from stock appreciation above the high strike.
The strategy can be used for index and sector-based ETFs. High strike options for indexes tend to be inexpensive relative to lower strikes.
Three-month SPDR S&P 500 ETF Trust (SPY) at the money calls recently generated a 5% premium. An SPY option with the same expiration date and struck 10% out of the money had a 0.5% premium.
The net premium from the strategy was 4.5%.
In the above example, if SPY increased 20% in price, the investor in the strategy captures a 10% increase in value plus the net premium.
Disclosure: I hold SNAP bull call spreads.
