Option Trading Strategies That Create Income
This is an introduction to various options trading strategies from basic trades to complex, multi-leg trades for generating streams of income from your investment portfolio. The profits and losses in these examples do not consider commissions, interest, or taxes.
Covered Calls - (Risk: Limited / Reward: Limited) Covered calls can be used to generate income from a stagnant stock. If you own a stock that you want to hold, but don't expect to move up in the short term, writing covered calls is a good, conservative strategy. By selling near month out-of-the-money calls, you can generate income if the options expire worthless. As with other option writing strategies, time decay is your friend. If the stock moves above the strike price prior to expiration, you can either buy your call back at a loss, or you can allow your shares to be called away from you at the strike price.
Sell Naked Calls - (Risk: High / Reward: Limited) Selling naked calls is one of the riskiest of all option strategies. Your downside is theoretically unlimited. When you sell naked calls you collect a premium for the sale of the contracts in hopes that the stock price will remain under the strike price past expiration. That way the options will expire worthless, and you keep the entire premium. If you are wrong, and the stock price rises above the strike price prior to expiration, losses can mount in a hurry. If you decide to employ this strategy, it's best to sell near term options since option prices decay quicker the closer you get to expiration.
Sell Naked Puts - (Risk: High / Reward: Limited) Like selling naked calls, selling naked puts is a high risk option strategy. However, since the underlying stock can only go down to zero, your loss potential is limited to that extent. When you sell naked puts you collect a premium for the sale of the contracts in hopes that the stock price will remain above the strike price past expiration. That way the options will expire worthless, and you keep the entire premium. If you are wrong and the stock price falls below the strike price, losses can mount in a hurry. If you decide to employ this strategy, it's best to sell near term options since option prices decay quicker the closer you get to expiration. Just like with naked calls, the faster your puts expire worthless, the better off you'll be.
Credit Spreads - (Risk: Varies / Reward:Varies) Credit spreads are any spread trade where the combination of trades creates a net credit for your account. In other words, you receive more premium for options sold than paid for options bought. With credit spreads, a trader makes their money on the time decay of the options. Essentially, you want the options to expire worthless so you can keep the net premium your account gained when the trade was placed.
Iron Condors - (Risk: Limited / Reward: Limited) The iron condor is similar to a condor trade. Therefore, this trade consists of four options over four strike prices. An iron condor differs in that its a combination of puts and calls, whereas the condor is either all puts or all calls. An iron condor trade is initiated by selling an out-of-the-money put and buying a put at a lower strike price, while also selling and out-of-the-money call and buying a call at a higher strike price. An iron condor could also be viewed as a combination of a bear call spread and a bull put spread. Maximum profit on a iron condor is achieved when the underlying stock or index trades between the two middle strike prices at expiration.
To learn about option trading strategies for other market conditions and situations, visit our option strategy overview page.
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