One strategy for earning income with derivatives is selling (or “writing”) options to collect premium amounts. Options often expire worthless, allowing the option seller to keep the entire premium amount.
Although there is a decent opportunity for profit, selling options can entail substantial risk. Derivatives are financial contracts whose value is derived from underlying assets. Options, along with futures contracts and forward contracts, are some of the most common types of derivatives.
Key Takeaways
- Several options strategies can generate income for investors through selling (writing) options contracts.
- Options income funds, covered call writing, and selling naked options short are all ways to produce premium income.
- Selling options come with risks, sometimes a high degree of risk, and so an investor should understand both the income potential and potential downsides before writing options.
Writing Options Basics
An option on a stock or exchange-traded fund (ETF) is a financial contract granting the buyer the right to purchase 100 shares of the underlying security at a certain strike price until the option’s expiration date.
The option buyer is not required to exercise the option. The seller of the option is collecting a premium as compensation for the obligation to deliver the shares to the option holder if the option is exercised. By selling options, an investor can collect premium amounts as an income stream.
Premium income originates from selling risk protection to some buyers seeking risk protection using options contracts. 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.
Covered Calls
There are many different option selling strategies. One option strategy is selling covered calls. An investor who owns shares of a stock can sell call options with a strike price above the current trading price to collect the premium.
If the option expires in the money, there is a likelihood the investor will need to deliver the shares to the option holder. If the price of the stock stays below the strike price until the option’s expiration date, the investor gets to keep the entire amount of the premium. This is a strategy with limited risk since the investor owns the shares of the underlying stock.
Note
American options can be exercised at any time up to and including the expiry date while European options can only be exercised on the expiry date.
Naked Shorts
Selling naked call options is another strategy that has unlimited risk. An investor sells options with no position in the underlying security and no other option to hedge the risk. If the option expires worthless, the investor gets to keep the entire premium amount. However, if the price goes against the sold option, losses can be substantial.
Options Income Funds
An option income fund, also known as an option income closed-end fund (CEF), is a type of pooled investment whose goal is to generate current income for its investors by earning premiums from selling options contracts. This can be done by selling delta-neutral options strategies such as straddles or strangles, or by writing covered calls, among other more complex strategies.
What Are the 4 Types of Derivatives?
Derivatives are financial instruments whose value is tied to an underlying asset, such as stocks or commodities. The main types of derivatives are options, futures, forwards, and swaps.
- Options provide the right (but not the obligation) to buy or sell the underlying asset at a set price on or before a specific date.
- Futures are contracts that allow for the purchase or sale of an asset at a set price on a specific date. Futures are standardized and traded on exchanges.
- Forwards resemble futures but are customized rather than standardized and are traded over the counter (OTC) rather than on exchanges.
- Swaps are agreements to exchange cash flows for a set period of time, primarily used for rates and currencies.
What Are the Negatives of Derivatives?
While derivatives can be beneficial to investors and useful when traded correctly, they do come with many negatives. They are complex instruments that come with risks and are not suitable for new investors. The leverage inherent in derivatives can maximize gains but they can also maximize losses. OTC derivatives come with counterparty risk and liquidity risk. Derivatives are widely used for speculative trading, which increases volatility and contributes to market instability.
How Do I Trade Derivatives?
To trade derivatives, you will need a brokerage account. You can open up an account with any broker that allows derivative trading. Once you open and fund the account, you can select the type of derivative you want to purchase (futures and options). Forwards and swaps are traded over the counter. Before engaging in derivative trading, you should understand the specific products, the risks, and what your losses could be. Trading derivatives isn’t for novices and should only be done by seasoned traders who understand the markets and products involved.
The Bottom Line
Selling options can generate steady income flows for investors, but there are also unique risks, especially with selling naked options, that should be evaluated before engaging in any strategy. Including techniques to manage risk, such as utilizing spreads or investing in options income funds, can help investors mitigate losses.
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