What are options, and how do they generate income?

When you think of investments to add to your portfolio, you probably think about stocks, bonds, commodities — even cryptocurrencies. Chances are that options don’t immediately come to mind. More investors are bringing options into their portfolios, however, because they can be useful tools for generating income and reducing downside risk, among other potential benefits. Access to professionally managed options-based strategies through exchange-traded products (ETPs) has never been easier. Here’s what options are and how they work.

What are options?

Options are a type of financial instrument that gives an investor the right — but not the obligation — to buy or sell a set quantity or dollar value of a particular investment at a fixed price by a certain date. The name comes from the choice (or option) received in the agreement.

Option contracts are two main types: call and put. 

• A call option gives the holder the right to buy the underlying asset at a certain price (the strike price) before it expires. 
• A put option gives the holder the right to sell the underlying asset at the strike price before it expires. 

How does a call option work?

The buyer of a call option believes the price of the underlying asset will increase in the future. If the asset price rises above the strike price during the specified term, the buyer can exercise the option. In other words, the investor can buy the asset at the lower strike price and sell it at the higher market price for a profit.

• Example: Say you buy a call option for a stock currently trading at $50. The call option has a strike price of $55 and expires in three months. If, within those three months, the stock’s price rises to $60, you can exercise your call option to buy the stock at $55 and then sell the stock at the $60 market price for a profit. If the stock’s price never surpasses the $55 strike price, however, the option becomes worthless. As the option holder, you aren’t obligated to buy the stock, but you would lose what you paid for the option (the premium).

How does a put option work?

The buyer of a put option believes the price of the underlying asset will decrease in the future. If the asset price falls below the strike price before the option expires, the buyer can exercise the option. In simple terms, the investor can buy the asset at the lower market price and sell it at the higher strike price for a profit.

• Example: Suppose you buy a put option for a stock currently trading at $50. It has a strike price of $45 and an expiration date of three months. If the stock’s price falls to $40 within that timeframe, you can buy the stock at $40 and exercise your put option to sell it at $45. If the stock’s price doesn’t go below the strike price of $45 in those three months, however, the option expires and becomes worthless. You forfeit the premium. 

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. That’s considered income. Option income strategies can effectively generate steady monthly income while maintaining exposure to stocks.

Option income has a different set of sensitivities and drivers than income from dividend-paying stocks or traditional bonds. For example, a primary risk of traditional bonds is interest rate risk, which the Federal Reserve (Fed) has increasingly influenced. Stock options avoid interest rate risk and can deliver high income regardless of interest rates or the Fed’s actions. Instead, option income is impacted by stock market volatility and strike prices. High stock market volatility leads to higher option premiums (and vice versa). 

What are the other 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 protect 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 favorably, 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 unfavorable 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 funds: For investors who want exposure to options without directly trading them, ETPs that use options strategies can make sense. Funds like Invesco QQQ Income Advantage (QQA) and Invesco S&P 500 Equal Weight Income Advantage (RSPA) are managed by professionals who use options to potentially enhance returns, generate income, and manage risk. This method provides a diversified and less complicated way to add options to your portfolio.

Common option terms

Call option: A financial contract that gives the holder the right — but not the obligation — to buy a specified amount of an underlying asset (usually in groups of 100) at a predetermined price within a set time period.

Expiration date: The date when an options contract becomes void and the right to exercise it no longer exists, ending the contract.

In the money (ITM): An options contract with intrinsic value, meaning a call option’s strike price is below the current market price of the underlying asset, or a put option’s strike price is above the current market price.

Option premium: The price that the buyer of an options contract pays to the seller for the rights conveyed by the option.

Out of the money (OTM): An options contract without intrinsic value, meaning a call option’s strike price is above the current market price of the underlying asset, or a put option’s strike price is below the current market price.

Put option: A financial contract that gives the holder the right — but not the obligation — to sell a specified amount of an underlying asset at a predetermined price within a set time period.

Spread: A trading strategy that involves simultaneously buying and selling two or more options contracts on the same underlying asset with different strike prices, expiration dates, or both to limit risk and potentially enhance returns.

Strike price: The predetermined price at which the options contract holder can buy (a call option) or sell (a put option) the underlying asset.

Underlying asset: The financial instrument, such as a stock, bond, commodity, or index, upon which the value of an options contract is based and which the option holder has the right to buy or sell.