While dividend and bond investing remain perhaps the most familiar methods of generating weekly or monthly income, using options contracts can accomplish a similar goal.
Options contracts give the holder the right, but not the obligation, to buy (call option) or sell (put option) a specific security. Those using options to generate income would sell these contracts to other traders and collect the premiums in the hopes that the contract expires ‘Out of the money’ (OTM).
To learn more, check out our introduction article on earning income with ETF options.
Generating income using options doesn’t, unfortunately, involve a simple buy and hold strategy. It involves close monitoring, frequent trading and an understanding of the many different options trading strategies that can be utilized.
ETFs That Offer Weekly Options
Many ETFs have options trading available. Options contracts can have a time to expiration lasting a year or longer, but many options income traders utilize weekly options (those that are set to expire within a week or less). The SPDR S&P 500 Trust ETF (SPY ) is the largest ETF in the marketplace and is also the most utilized for options trading. Some of the other most frequently traded options contracts are based on the iShares MSCI Emerging Markets ETF (EEM ), the iShares Russell 2000 ETF (IWM ), the SPDR Gold ETF (GLD ) and the PowerShares QQQ ETF (QQQ ).
Using more heavily traded options contracts for income generation is important because thinly traded contracts can be expensive. They can cost more to buy and less to sell and may be difficult to unwind.
There are a number of different options strategies that can be implemented. Some may be more appropriate than others depending on your goal and where you think the underlying security price might be headed.
Covered Calls
Covered calls involve holding a long position in an ETF while, at the same time, writing (or selling) a call option on the same security.
In a covered call strategy, the holder of the position profits as long as the price of the ETF doesn’t fall more than the premium received for writing the option. The upside of the strategy, however, is limited to the strike price of the option – since, theoretically, the person you sold the call option to would exercise it once it became ‘In the money’ (ITM).
For more details on the covered call strategy, read this article:
Covered Puts
Covered puts involve holding a short position in an ETF while, at the same time, writing (or selling) a put option on the same security.
A covered put strategy is a bearish one in which the holder looks to profit if the ETF price holds constant or falls. Like the covered call, the upside of the covered put strategy is limited to the strike price of the put contract. In theory, the downside of a covered put is unlimited since there is no limit to how high a stock price can rise.
For more details on the covered put strategy, read this article:
Short Straddles
A short straddle is a strategy that involves selling a call option and a put option on an ETF at the same time with identical strike prices and expiration dates.
A short straddle position would be implemented by someone who believes that the price of the underlying ETF will move relatively little up or down until the expiration date. The risk of a short straddle position can be high. The potential for losses is significant if the price of the underlying ETF moves sharply in either direction. The maximum profit point would be at the strike price. The holder would collect both options premiums and both would expire ‘At the money’ (ATM).
Credit Call Spreads
A credit call spread (also known as a bear call spread) involves selling call options at a certain strike price while buying the same number of call options at a higher strike price.
The maximum profit in a credit call spread is the difference between the premium received on the options sold and the premium paid on the options purchased. A trader who initiates a credit call spread anticipates that the price of the underlying will go down, but has downside protection in case the price happens to rise.
Credit Put Spreads
A credit put spread (also known as a bull put spread) involves buying put options at one strike price while selling the same number of put options at a higher price.
Those opening a credit put spread position generally believe that the ETF price will rise. Like the credit call spread, the maximum upside is the difference between the price of the puts sold and the price of the puts bought.
For more strategies, visit our ETF Trading Strategies category page on a regular basis.
Using Technical Indicators to Guide Decision Making
Technical analysis can be a useful tool in helping traders decide at what point they should anticipate an upward or downward movement in the market. Technical analysts attempt to forecast price movements by examining past trading patterns, volumes and chart movements. It’s not a foolproof method of pinpointing when to buy and sell, but it operates on the belief that the markets are not perfect and can be taken advantage of.
One popular technical indicator is the Bollinger Bands. The Bollinger Bands take a simple 21-day moving average and plot an upper and lower band that are two standard deviations away. It is theorized that a movement toward the upper band is a bearish signal, while a move toward the lower band is a bullish one. Depending on where the moving average sits relative to the bands, traders could enter into bullish or bearish strategies described above at that time.
What Happens to Options at Expiration
Once an options contract passes its expiration date, it becomes worthless regardless of whether it’s ITM or not. An options contract needs to either be exercised or the position needs to be closed out prior to its expiration. OTM options are generally allowed to expire, or are sold prior to expiration while they still have some value. ATM options are occasionally exercised, but there is no profit or loss in doing so. In-the-money options need to have an action taken prior to expiration.
Some brokerages will set up an “automatic options exercise,” in which it will exercise any options that is in the money just prior to its expiration.
For additional income, check out a list of the top dividend ETFs using our ETF Screener.
The Bottom Line
Buying and selling options can be confusing and complicated. Moreover, it can result in significant losses if the strategies are implemented incorrectly or the market moves in a way you didn’t anticipate. It generally involves a level of sophistication and monitoring that goes beyond normal buy and hold investing. They can, however, be a great tool for adding regular income to your overall portfolio.
Further Reading
To learn more about some specific options trading strategies in more detail, check out the rest of our ETF Options Income Series:
