Writing Options Can Be a Great Way to Generate Income
With interest rates having been low for years, investors are constantly on the lookout for ways to generate income.
With term deposits, you will be lucky to get more than 2.5%.
And cash management accounts? You might be lucky to get 1.5%. And, you may have to maintain a minimum amount to receive any interest at all.
One way, as you know, is to buy shares. By buying shares, you can collect dividends paid out by the company. Most of the blue chip stocks pay out dividends twice a year.
In recent times, a range of exchange traded fund providers have released products that pay out dividends quarterly. These have been popular with those on the hunt for more regular income.
Another popular strategy is to write call options. When you write a call option, it means that your initial trade is to sell an option. Note that this is different to selling an option that you have already bought.
What does it mean?
By writing a call option, you are agreeing to hand over your shares at the option’s strike price, if the buyer exercises the option.
So, if you write a call option with a $5 strike price, that means handing over those shares at $5.
The reason investors write options is to generate extra income. To compensate them for the obligation they are taking on, the option buyer pays the option writer a premium.
Options on the big blue chips normally have expiries every month. So, an option writer can go into the market regularly to capture this premium income.
However, writing call options is not a set and forget exercise. If the share price rallies above the option’s strike price, you have to make a decision.
That is, to buy the option back or, let the buyer exercise the option.
If the share price jumps well above the strike price, it could cost more to buy the option back than what you sold it for.
If the buyer exercises the option, it means that the share price is likely above the strike price. Otherwise, there is no point in them exercising the option. Meaning, that you are missing out on profits.
While writing options over shares can generate income, the cost can also become excessive. Brokerage for options is usually much higher than shares.
It is not uncommon to trade shares for as little as $10. But options? Typically you will pay somewhere around $35, or higher.
If you write options regularly over a wide range of shares, you might be surprised at how much the brokerage eats away at your account.
There is, however, another way to generate income from writing call options. A way that doesn’t leave you scrambling to buy back the option if the share price goes for a run. Nor, paying out a bucket load of brokerage.
That is, to write options over the index. In the local market, that means the ASX 200.
Another instrument to consider
Index options are cash-settled. Because of that, you don’t have to hand over any shares if the buyer exercises your call option. Instead, money either lands in or comes out of your account at expiry.
Another difference is the style of option. Share options can be either American or European-style.
A buyer of an American-style option can exercise the option at any time until expiry. By contrast, you can only exercise a European-style option at expiry. Because index options are European, you don’t have to worry about early exercise.
If you have a broad range of shares, you can still generate income by writing a call option over the index. However, because the index covers a broader number of stocks, it might track differently to the shares in your portfolio.
Writing call options without owning the underlying shares is an absolute no-no. If the share price spikes, and the buyer exercises their option, you will find yourself scrambling to buy the shares (to hand over).
To write call options over the index, however, you don’t have to own a broad array of shares. Instead, you can buy one of the aforementioned ETFs.
There are plenty of ETFs on the market that replicate the ASX 200. You can buy an ASX 200 index ETF, and write call options over the ASX 200 to generate income. In writing an index option, you are only paying for one lot of brokerage.
Due to the flexibility of options, you can do this monthly — even weekly, the closer you are to expiry.
Any option that expires without exercise ceases to have any value. This is what the option writer is trying to capture — time decay. In other words, using time for their side.
However, there is a big difference between share and index options. Share options are typically for 100 shares. With an index option, it has something called a multiplier.
In this case, the position’s value is the index option’s strike price, multiplied by 10. So, if you write a call option with a 6,300 strike price, the value of the position is $63,000.
Meaning, that you need to own at least $63,000 worth of shares, or of an index ETF, before considering writing a call option on the index.
Writing options over shares can be a great way to generate income. However, it is not the only way to generate income from options. Don’t forget that you can write options over the index as well.
All the best,
Editor, Options Trader
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