This article is an introduction in my series on Options Trading, where I’ll explain these complex-sounding tools and show you how to use them to your advantage.
What Are Option Premiums? #
Think of an option premium as a fee that a buyer pays to a seller for a specific right related to a stock, without the obligation to use that right.
In the world of options, there are two main types of contracts:
- Call Options: Give the buyer the right tobuya stock at a specific price (the “strike price”) before a certain date (the “expiration date”).
- Put Options: Give the buyer the right tosella stock at a specific price before a certain date.
When you sell one of these contracts to another investor, they pay you an upfront fee. That fee is the option premium. It’s yours to keep, no matter what the stock does or whether the buyer decides to exercise their right.
How Can I Benefit from Option Premiums for Passive Income? #
As a seller (also known as a “writer”) of options, you are essentially selling a form of insurance to other investors. They are hedging their bets, and you are collecting a fee for providing that service.
Two of the most popular and relatively conservative strategies for earning premiums are:
- Selling Covered Calls:
If you already own at least 100 shares of a stock, you can sell a “call” option against it. The buyer pays you a premium for the right to buy your shares at a higher price. If the stock doesn’t reach that price, the option expires, and you keep your shares plus the premium. This is like collecting rent on your stocks.
- Selling Cash-Secured Puts:
If there’s a stock you’d like to own at a lower price than it is today, you can sell a “put” option. You collect a premium for agreeing to buy the stock at that lower price. If the stock stays above your target price, the option expires, and you simply keep the premium. If it drops, you get to buy the stock you wanted at a discount, and you still keep the premium.
By repeatedly selling these contracts, you can create a consistent stream of income from your portfolio. Selling Puts is my preferred choice.
Covered Call Flow #
graph TD
A["Own 100 Shares of Stock"] --> B{"Sell Call Option"}
B --> C["Collect Premium"]
C --> D{"At Expiration: Stock Price below Strike?"}
D -- "Yes" --> E["Keep Shares + Keep Premium"]
D -- "No" --> F["Shares Called Away at Strike Price + Keep Premium"]
Cash-Secured Put Flow #
graph TD
A["Set Aside Cash"] --> B{"Sell Put Option"}
B --> C["Collect Premium"]
C --> D{"At Expiration: Stock Price above Strike?"}
D -- "Yes" --> E["Keep Cash + Keep Premium"]
D -- "No" --> F["Buy Shares at Strike Price + Keep Premium"]
What is the Risk? #
Critical Warning: It’s absolutely crucial to understand that selling options is NOT “free money.” This strategy comes with significant risks that you MUST manage carefully. Never enter an options trade without fully understanding the potential downsides.
It’s crucial to understand that this is not “free money.” Selling options comes with its own set of risks that you must manage.
-
Risk of
Selling Covered Calls: The primary risk is an opportunity cost. If the stock you own shoots up in price, far beyond your strike price, the buyer will exercise their option. You’ll be forced to sell your shares at the agreed (lower) strike price, missing out on those extra gains. You still profit, but not as much as you could have. Just happened to me while writing this article. CAKE just spiked above my strike. Considering that CAKE has upside potential, I’ll close my covered call option. -
Risk of
Selling Cash-Secured Puts: The risk here is that the stock’s price could fall dramatically. You are obligated to buy the stock at the strike price, which might be much higher than the current market price. This is why you should only sell puts on stocks you genuinely wouldn’t mind owning for the long term.
In both cases, you are trading unlimited upside potential for a smaller, but more consistent, upfront gain.
Is It a Good Strategy for Passive Income? #
Selling option premiums can be an excellent addition to a long-term investment strategy if managed correctly. I’ve made consistent income over the past 5 years.
- It generates cash flow: It provides a regular income stream, separate from dividends or stock appreciation.
- It can lower your cost basis: The premiums you collect can be seen as a discount on the stocks you own or want to buy.
- It requires active management: While we call it “passive,” it’s not a set-it and forget-it strategy. You need to monitor your positions and be prepared to act as expiration dates approach.
For those willing to put in the time to learn, selling option premiums offers a compelling way to unlock a new income stream from your investments.
In my next articles in this series, I’ll walk through with step-by-step examples of selling covered calls and selling cash secured puts. Stay tuned!