Getting started with options trading: Part 2

In Part 1, we covered the basics of call and put options. When you buy these options, they give you the right to buy or sell a predetermined amount of stock or other units of other investments like ETFs.

Now, let's take a look at two ways you can use options to potentially generate income. Both methods involve selling options. More precisely, they involve writing/selling a new call option contract that obligates the “writer” (you) to sell shares of stock at a specified price during the life of the contract. (This is different than selling an options contract that you previously bought.) When you buy an option, as we described in Part 1, you pay the premium; when you sell (write) an option, you collect the premium.

We'll use options on stocks for our examples again, but remember that the same principles apply to options on ETFs and other kinds of securities.

You can use the covered call strategy when you already own a stock. Simply put, you sell someone the right to buy your stock, for a price you're willing to accept, within a certain time period.

Let's say you buy 100 shares of Purple Pin Company at $90 per share, and you're willing to sell the stock and take the profit if it reaches $100 per share. You could enter a limit order to sell the stock at $100 and then hope the price goes that high. Or you could consider selling a covered call to generate some income while potentially achieving the same result.

Here’s how it would work: Imagine that you sell a call option that obligates you to sell your stock for $100 per share—this is known as the strike price—for a period of 30 days. Let’s also suppose that the premium for this option is $1.50 per share. Since a standard options contract is for 100 shares, you collect $150 total premium.

If the price of the stock goes above $100 before the option expires in 30 days, the owner of the option will exercise it. You'll sell your stock for $100 per share, and you'll also keep the $150 you collected. In that scenario, your profit is $11.50 per share. You bought the stock for $90 and sold it for $100 when the call was exercised, generating a $10 profit. Plus, you collected a premium of $1.50 for the covered call for a total of $11.50. Multiply that by 100 shares and you made $1,150 in profits on a $9,000 investment.

On the other hand, if the price of the stock does not go above $100 within 30 days, the option will expire unused, and you'll still own your stock. Plus, you still keep the $150 premium. So you've essentially lowered your cost on the stock by the $1.50 per share that you received. Then, you could potentially repeat the process by selling another call with a different expiration date and collecting another premium.

When you sell the call option, you get to choose from a range of strike prices and expiration dates. The amount of the premium is determined by the market—i.e. by what buyers are willing to pay—and it will vary, depending on the strike price and expiration you choose.

A second strategy to potentially generate income with options is the cash secured put, which you might consider when you want to buy a particular stock.

Let's say you'd like to buy the stock, but the current market price is higher than you’re willing to pay. One approach is to enter a "good-til-cancelled" order, which will buy the stock for you if it drops to a limit price you set. Then you wait to see what happens.

But if you're willing to wait, why not be paid to do so? That's what the cash secured put strategy potentially does. You take on an obligation to buy a stock if it falls to a lower price, which you choose, before an expiration date that you also choose. You are paid a premium in return for taking on that obligation.

How does it work? Imagine you want to buy shares in Purple Clothing Company, which is trading at $100 per share. You don't want to pay that much, but you're willing to pay $95. You could sell a 30-day put option with a strike price of $95 and collect a premium—for this example, let's say it's $2 per share, or $200 for a standard 100-share contract.

If the stock drops below that $95 price within 30 days, you're obligated to buy it and to pay $95 per share (even though the market price is lower). You buy the stock for the price you originally targeted, plus you keep the $200 premium.

If the stock does not go below $95 within 30 days, the put option will expire. You won't buy the stock, but you keep the $200 premium you collected. And of course, you could sell another put and repeat the process, collecting more premiums and perhaps eventually getting the stock at the price you choose.

By now, you should be getting a pretty good idea of the flexibility that options can provide and how traders use them for different purposes such as seeking a profit, protecting a position, and potentially generating income. But we've only scratched the surface.