Options can be a source of extra income to long term investors, when used properly. There are risks to using options, so be warned that this instrument is not for everyone. However, the risks in these strategies are controlled in terms of real losses, and leave more exposure on missing out on gains. The two methods discussed here are some of the most basic strategies, but both require an existing position of at least 100 shares in the underlying stock.

Covered Calls

This strategy is performed by simply selling Call options of a stock held in the portfolio.

When the stock price stays below the strike price, the option expires worthless, the full premium received during the initial sale of the option is kept, and the stock is retained in the portfolio.

When the stock price rises above the strike price, the option is exercised, the full premium received during the initial sale of the option is kept, but the stock is called away and the value of the stock position at the strike price is received. The investor would also have the opportunity to buy back the option at a loss if they don’t want to have their stock called away.

This strategy is used to generate income on a position that you intend to continue holding in the portfolio for the long term, but believe it will be staying around the same price or experience a drop in price in the short term. Covered calls can also be used on stocks that you are looking to sell anyway, and can generate some extra income while waiting for it to eventually get called away once it hits the strike price.

The main risk of using covered calls is that the underlying stock has a large unexpected rise in price. Since the option locks in the maximum value that you receive for the stock, any gains above that strike price are missed. Another less significant risk is that you must maintain your position in the underlying stock, even if it has a larger than expected drop in price, or you must buy back the stock option before selling the stock (although the option will be significantly cheaper at this point too).

A key element of using covered calls is identifying the right strike price. Unfortunately there is no right answer, but depends on the stock itself and how the investor wants to handle the potential outcomes. One strategy is to use a strike at the money, anticipating a drop in price. Another strategy is to have a standard margin of safety, such as the strike closest to 10% above the current price, however this will generate a smaller premium.

Protective Put

This strategy is performed by simply buying Put options of a stock held in the portfolio.

When the stock price falls below the strike price, the option value increases, offsetting the losses of the underlying stock position. The investor is then able to sell the put option for a gain while continuing to hold the stock, or exercise the option and sell the stock at the strike price valuation.

When the stock price stays above the strike price, the option expires worthless, and the stock is retained in the portfolio. The investor only loses the option premium in this scenario.

This strategy is used to insure gains, or protect against future losses, on a stock holding. By defining the lowest price to sell the stock, via the strike price, the investor can be assured that the value of their position will not drop below that level. Buying puts can also be used when there is a drop in the stock price expected in the near future to protect against the downside risk of holding a stock.

The risk of Protective Puts is very controlled and limited to the premium paid for the option contracts. Maintaining a Protective Put position across several positions over time can get expensive to maintain if the stock is not paying a dividend or making significant gains to make up the costs of the premiums.

As with Covered Calls, a key element is identifying the right strike price to buy the options at. One strategy is to purchase options at the money, which captures any change from the current level. Another is to purchase options with a strike price near the break even point for your stock holding, which would protect against losses but not help to retain any existing gains.