Trading options doesn't have to be risky. In fact, options can be a great risk mitigation strategy for your portfolio and can increase your income. Here is how to trade options for income.
My friend, Gavin McMaster, is a day trader and options trading blogger for his site OptionsTradingIQ.com. He's very sophisticated with trading options and trades full-time. I was very eager to have Gavin join me on the Financial Wolves blog to help you understand how you can boost your income trading options.
With that being said, take it away, Gavin…
Trading is often associated with glamorous lifestyles, mansions, private jets, and excessive partying. This image of a trader might have been promoted by Hollywood movies that tend to mislead viewers into believing that trading is an easy way to get rich quickly.
Yes, trading options can bring you tons of money and make you rich. But the fact is that certain elements have to be in place to achieve that goal.
In contrast, most humans that intend to make money out of trading options just want to earn a side income from their investment funds.
That said, trading options for income may be the first step towards building a sizable portfolio that might eventually become the cornerstone of your wealth if you play your cards right.
Keep reading to find out how you can trade options for income through 4 different time-tested strategies.
Table of Contents
The Truth About Trading Options for Income
Most people associate investment success with nailing large returns on individual trades.
Stock tips and ‘hot’ investments are usually seen as the express tickets to riches, even though one of the most fundamental theories behind investing is the relationship between risk and reward.
While you could identify and successfully invest in one stock or option and make a killing, committing a significant portion of your funds to a single security exposes you to high rewards and a significant risk of losing all your money.
The truth is that trading options for income are not a get-rich-quick scheme. Instead, it systematically implements a set of strategies intended to yield consistent results over time.
Your portfolio’s performance may not land the headlines of your local newspaper. Still, it should definitely provide additional income while progressively building a sizable amount of capital that might open the doors to more attractive investment opportunities.
Setting Your Expectations with Options Trading
How much can you earn by trading options for income? Can you achieve a six-figure income through it? Is it possible to make a living out of trading options?
The answer to all of these questions is YES. But achieving that ‘yes’ is intimately related to some of the following elements:
- The amount of capital you are willing to invest: Trading options for income is mostly a numbers game.
Most experienced traders aim to achieve 1% – 2% monthly portfolio returns without incurring significant risks.
This means that to produce $5,000 per month, you must have around $250,000 to $500,000 available for your trading operation.
Most people don’t have that kind of money lying around, which means that you have to build a portfolio progressively by reinvesting your gains and wisely allocating your money.
- The time you are willing to commit to trading: Most people who want to start trading also have a day job that demands a significant portion of their time.
Trading options for income, like any other activity you wish to pursue, requires time, discipline, some degree of study, and practice.
Your trading success is directly related to the time you invest in learning and implementing your trading strategies until you develop the expertise that will produce consistent returns.
- The right mindset: There are a lot of behavioral traps involved in trading that may drive you to make irrational decisions or expose you to unnecessary risks. Traders must develop the right mindset to ensure their prejudices and insecurities don’t act against their trading goals.
Now that you know what to expect from trading options, here are some strategies you can start learning and practising to build up your own money-making machine.
You can start trading options for completely free with the Robinhood app. No commissions and no strings attached.
Want other commission-free apps? These apps will give you free stocks simply by signing up.
Best Strategies for Trading Options for Income
Let's dive into some straightforward options trading strategies that will increase your income yield.
Strategy #1: Selling –Puts
If you have already set your mind on investing in a certain security, planning that its value will increase over time, selling a put is an easy way to generate income.
Doing this also allows you to buy the stock at a price lower than the current traded price.
A put option gives the holder the right, but not the obligation, to sell the stock at a certain strike price at or before the option expiry.
Traders selling put must be willing to take ownership of 100 shares of the stock at the strike price.
Here is an Illustration.
Suppose you want to buy Apple stock (AAPL), currently trading at $315. You could sell a put that expires in 1 month at a strike price of $315.
Selling a $315 strike put might generate $12 or more per each option you write. Each option is usually comprised of 100 shares, which means you’ll earn $1,200 as a premium for writing the put.
If the price of AAPL ends up being the same or higher (remember you are bullish on the stock), the option will expire worthlessly, and you’ll keep the $1,200 you previously earned as a premium from writing the put.
On the other hand, if the stock decreases in value, even though you may lose money from having to buy the stock at a higher price, a portion of your losses will be offset by the premium earned. You’ll end up owning the stock as a result, which was something you intended to do in the first place.
Here is a snapshot of your returns under the above-mentioned scenario.
Once you own the stock, you can collect the dividends and sell covered calls, which leads us to strategy number 2.
Start selling put options with Robinhood with no commissions. You'll even get a free share of stock for signing up.
Check out these top Robinhood alternatives if you can't access Robinhood and want something more comprehensive.
See Related: Best Dividend Income Trackers to Use
Strategy #2: Covered Calls
A covered call is an option-trading strategy that consists of selling or ‘writing’ call options on your current stocks.
A call option gives the holder the right, but not the obligation, to buy a stock at a certain strike price at the option's expiration date.
Covered calls are great if you have a neutral to a slightly bullish view of the stock.
The writer earns a premium by writing a call on the underlying security. If the stock’s price remains the same or drops, the option will expire worthlessly, and the writer gets to keep the underlying security PLUS the premium earned.
On the other hand, if the security increases in price, the buyer of the option may exercise the option, and the writer will have to sell the stock at the strike price.
Since the writer predicts that there will be little to no change in the underlying security price, this strategy should result in a benefit equal to or similar to the premium collected from writing the call option.
Here is an illustration.
Let’s say you currently own 300 shares of AT&T Inc. (T), currently priced at $39.
If you expect the stock to remain fairly flat over the next 3 months, you can write 3 call options on these shares.
Using a strike price of $40 allows you to collect around $0.73 in premium per share, so $219 in total before the commission.
If the price of AT&T’s stock remains below $40 by the expiration date, you’ll generate an extra $219 in income from your shares PLUS any dividends you received during that time.
If the stock increases over $40, you’ll have to sell the stock at $40, losing any further capital gains in the process.
A covered call would generate extra income from the stock if you were already planning to sell the underlying security, a.
Under the scenario outlined above, here are the profit scenarios for ATT.
See Related: YieldStreet Review – Invest in Alternative Assets
Strategy #3: Vertical Spreads
Vertical spreads are a more complex way to trade options for income compared to the previous two strategies, as they require a set of interrelated transactions that must be properly understood.
This strategy is a limited-risk, limited-reward approach since it puts a cap on the potential losses the trader may face while also putting a maximum limit on the gains.
There are two vertical spreads, depending on the trader’s view of the underlying security’s future performance. These are bull spreads and bear spreads.
Additionally, they are subdivided into bull call and put spreads and bear call and put spreads.
Each strategy consists of buying and selling options with different strike prices that expire on the same date.
Depending on the trader’s expectations of the behavior of the underlying security, the trader may choose among these four strategies to profit from the directional movements of the security’s price.
Selling vertical spreads is a great way to generate income while also allowing a small margin for error if the trader’s direction view is wrong.
See Related: How to Invest a Small Amount of Money
Strategy #4: Iron Condors
An iron condor strategy involves trading four options contracts with different strike prices but the same expiration dates.
The strategy involves selling an out-of-the-money call and put and then buying calls and puts further away from the current stock price.
Because the purchased calls and puts are further away from the money that the calls and puts are sold, the traders receive a net premium for placing the trade.
Iron condors are the most popular income trade for options traders.
Trading an iron condor involves combing a bull put spread and a bear call spread.
Even though this strategy is mainly used when the trader’s sentiment towards the future performance of the underlying security is neutral, the trade can actually profit in several ways.
Stocks can move one of five ways during the life of an iron condor:
- Up a lot
- Up a little
- Sideways
- Down a little
- Down a lot
Stock investors can only make money in the first two scenarios.
Iron condor traders will make money in the middle three scenarios. Hence, they are a fantastic addition to a portfolio that can help investors outperform during flat years for the general market.
Losses are capped by the call and put options bought. At the same time, profits are also capped, with the maximum profit realized if the security’s price remains neutral and a net premium is collected from the options sold minus the smaller premiums paid on the options bought.
See Related: How to Invest in a Company
Conclusion on Trading Options for Income
Trading options for income is highly rewarding for traders that know what they are doing. It’s important to have a solid grasp of option fundamentals before diving into this trading style.
There’s no guarantee that you’ll be able to generate steady returns within the first few months. Still, as time passes and you learn to identify potential targets for these strategies, you'll move one step closer to producing a reliable source of income from trading options.
Start trading options with Robinhood with no commissions. You'll even get a free share of stock for signing up.
Do you know how to trade options for income? Let us know if you have any questions.
FAQ
Is trading options profitable?
Absolutely! You can make a considerable return on investment if you trade options and the stock price significantly moves beyond the strike price.
What are the types of options?
There are four basic types of options: buying a put option, selling a put option, buying a call option and selling a call option.
How many times can I buy and sell options in a day?
According to the day-trader rules, retail investors can't buy or sell the same stock over four times within 5-business days.
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