What are options, and how can they generate income?

Options are versatile financial instruments that can be used to generate income, manage risk, and enhance investment returns. Understanding how options work and their potential benefits and risks is crucial for any investor looking to incorporate them into their portfolio.

Most investors who know anything about options probably think about them from the perspective of the buyer. If you think the price of an asset will go up, you could buy a call option that gives you the right to buy that asset at a certain price in the future. If you expect the asset to fall, you could buy a put option that gives you the right to sell it at a certain price.

Hedge funds and other professional investment managers, however, can use options in another way. They will often sell the options as part of their strategy, using the premium (the price of the option) to produce a potentially greater return. If the asset doesn’t reach the strike price by the expiration date, the option becomes worthless, and the seller pockets the entire premium.

What are options?

An option is a contract between two parties for the right to trade a specified asset at a specified price on or before a specified date. The underlying asset can be a commodity, an individual stock, a bond, an index, or anything else that can be standardised. 

Many options are settled in cash. For instance, the buyer of a call option on the S&P 500 index will receive a cash settlement if the buyer exercises the option. The seller of a call option will have to pay the cash settlement if the buyer exercises the option.

For clarification, an option contract isn’t between two specific individuals. Options are traded on an exchange, where buy and sell orders are matched automatically. The administration of the contract is handled by a clearing house, which deals with each individual directly. Clearing houses keep track of the contract positions (who holds what) and margin requirements. 

What is margin?

When someone buys an option, the most they can ever lose is the premium paid for the option itself. That’s the maximum risk for that one option, and that’s the most the clearing house would ever ask for the buyer to deposit with them.

For the seller of an option, the most they can ever profit is the premium received. The potential for loss is much greater and, in theory, can even be unlimited in some cases. Clearing houses require the seller of options to maintain a certain level of margin with them, for protection in case things go wrong. Margin is set by a defined calculation.

A seller of a call option can reduce their risk – and potentially the margin required – by holding the underlying asset. This simple strategy is known as a “covered call”.

A seller of a put option is in a different situation, because holding the underlying asset doesn’t help them. Instead, the put seller could set aside the amount of cash that would be needed to buy the asset if the option is exercised. This is known as a “cash-secured put” strategy. 

How do options generate income?

When an investor sells an option, they give the buyer the ability to buy or sell a specific asset by a certain date at a predetermined price. In return, the seller collects an option premium from the buyer. This premium is considered income. Option income strategies can effectively generate steady monthly income while maintaining exposure to stocks. In contrast to bonds, option income is impacted by stock market volatility and strike prices (high stock market volatility can lead to higher option premiums, and vice versa), rather than interest rates or actions from the Federal Reserve. 

What are the benefits of options?

Options can serve a broader purpose in a portfolio. Here are five other potential benefits.

1. Leverage: Options let investors control a large position with a relatively small investment. This leverage can amplify potential returns, helping investors benefit from price movements without committing substantial capital.
2. Hedging: Investors use options to safeguard against potential losses in their portfolios. Put options, for example, can offset, or hedge, declines in the value of their underlying assets.
3. Speculation: Buying call or put options lets investors bet on price movements without owning the underlying asset and potentially reap significant rewards if they’re right.
4. Flexibility: Options offer a variety of strategies for different market conditions and investment goals ranging from conservative income generation to aggressive growth.
5. Risk management: Options can be used to strategically fine-tune a portfolio’s risk profile, managing exposure to market volatility, interest rate changes, and other types of risk.

What are the risks of options?

Options are far from risk-free, especially for an inexperienced investor. Here are five inherent risks. 

1. Complexity: Options trading requires a deep understanding of various strategies, market conditions, and pricing models, which can overwhelm inexperienced investors.
2. Time decay: Options are time sensitive, and their value diminishes as the expiration date approaches. Even if the underlying asset moves favourably, the option may still lose value if it doesn’t move quickly enough.
3. Leverage risk: While leverage can amplify gains, it can also magnify losses. Investors using options to leverage their positions may face significant losses if the market moves against them. Therefore, fully collateralizing or “covering” options may be appropriate for managing leverage risk.
4. Liquidity issues: Options on less popular underlying assets may suffer from low liquidity. This can make it difficult for investors to enter or exit positions at desired prices, potentially leading to unfavourable trades.
5. Costs and fees: Trading options can involve higher transaction costs and fees than trading other investments, particularly if the underlying stocks are less liquid. Additional costs can reduce potential profits and make frequent trading less viable for investors.

How can investors buy and sell options?

Investors who understand options and want to include them in their portfolios can get exposure to them in a variety of ways. 

1. Trade options themselves: Investors can buy and sell options through online brokers and specialized options trading platforms. They must apply for trading privileges, which may require meeting certain criteria and passing a test.
2. Financial professionals: Investors looking for a more hands-off approach can work with a financial professional with expertise in options trading. They can help develop and execute options strategies tailored to the investor’s financial goals and risk tolerance.
3. Options-based ETFs: ETFs that use options strategies can provide a diversified and less complicated way to add options to a portfolio.

Terminology

OK, so let’s spell out what all the terms mean.

Call – an option to purchase the underlying asset; the buyer of a call option has the right to buy the asset, whereas the seller of the call has an obligation to sell it if the option is exercised

Put – an option to sell the underlying asset; the buyer of a put option has the right to sell the asset, whereas the seller of the put has an obligation to buy it if the option is exercised

Premium – the price of the option as determined by the buyers and sellers (note the option premium is entirely different than the strike price); the premium consists of two components: intrinsic value and time premium (see below for descriptions)

Strike price – the price that the underlying asset would be traded at if that option is exercised; strike prices are set at standard intervals according to the contract specifications.

Contract month – the month the option contract expires; the months are set by the exchange and can be found in the contract specifications.

Expiration date (expiry) – the exact date the option expires

Long – the position of someone who has bought the option, e.g., long call or long put

Short – the position of someone who has sold the option, e.g., short call or short put

At-the-money – an option with a strike price equal to the current price of the underlying asset

In-the-money – an option that has positive value if it was exercised at that moment, e.g., a call option that has a strike price below the current price of the underlying asset

Out-of-the-money – an option that has no value isf it was exercised at that moment, e.g., a call option that has a strike price above the current price of the underlying asset

Intrinsic value – how much the option is “in the money” (note that an at-the-money or out-of-the-money option will have no intrinsic value)

Time premium – the value of an option beyond its intrinsic value; time premium is determined by the buyers and sellers (what they think the option is worth) and can be influenced by volatility (see below) and the number of days before the option expires 

Time decay – all else being equal, an option’s time premium will erode (or decay) throughout its lifetime, and this time decay accelerates closer to the expiration date

Volatility – a measurement of the price fluctuation of the underlying asset; an option’s price will increase as volatility in the underlying asset increases, and decrease if volatility decreases

American style – options that can be exercised at any time up to expiry

European style – options that can be exercised only at expiry

Investment risks

Options Risk: Options or options on futures contracts are subject to correlation risk because there may be an imperfect correlation between the options and the securities or contract markets that cause a given transaction to fail to achieve its objectives. Exchanges can limit the number of positions that can be held or controlled by the Fund or the Sub-Investment Manager, thus limiting the ability to implement the Fund’s strategies. Options are also subject to leverage risk and can be subject to liquidity risk.

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

Investments focused in a particular sector, such as technology, are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.

There are risks involved with investing in Exchange-traded Funds (“ETFs”), including possible loss of money. Index-based ETFs are not actively managed, and the return of index-based ETFs may not match the return of the Underlying index. Actively managed ETFs do not necessarily seek to replicate the performance of a specific index. Both index-based and actively managed ETFs are subject to risks similar to those of stocks, including those related to short selling and margin maintenance requirements. Ordinary brokerage commissions apply. Equity risk is the risk that the value of equity securities, including common stocks, may fail due to both changes in general economic and political conditions that impact the market as a whole, as well as factors that directly related to a specific company or its industry.