Option Income Strategy

My Option Income Strategy generates monthly option premium income through the sale of ‘covered’ call options. The sale of the call option is covered by the underlying stock or by a long term LEAPS option. For novice option investors this strategy may be difficult to grasp initially but it is well worth the effort as this strategy has one of the best reward/risk ratios available and has been performing well during the recent volatile markets.

Option premium consists of time value and intrinsic value. At option expiration options lose all time value and consist of only intrinsic value. The graph below displays the typical time decay characteristics of options. You can see from the graph that the time value portion of an option decays very rapidly during the month prior to expiration. At option expiration the time value declines to zero. Notice how LEAPS options lose very little time value until several months prior to expiration. Buying stock or a LEAPS option and selling a short term one month option allows you to profit from the time decay characteristics of options.

For example, Mosaic (MOS) is an agricultural company that qualifies as both a MVP and Wealth Building Formula stock. Today is December 26^th 2007 and I purchased 10 of the Mosaic January 09 75-Strike LEAPS call options which expire in 13 months for 33.67 points. And I sold to open 10 Mosaic January 08 95-Strike calls which expire in less than 1 month for 5.67 points (see brokerage confirmation below). The cost of this spread was $2,800 ($3,367 - $567 = $2,800).  

The purchase of the Mosaic LEAPS option and the sale of the t profits from the very rapid time decay of the short option. Mosaic stock was trading at 93.50 when I initiated the spread. The one month 95-Strike call I sold for 5.67 points was an out-of-the-money call that consists of only time value. At option expiration the 5.67 points of time value will decay to zero and will produce an $567 profit in my trading account regardless of the price movement of Mosaic stock. At option expiration in less than one month if Mosaic stock closes at or above the 95-Strike price of the short call then the full profit potential for this trade will be realized.  

Let’s assume Mosaic stock increases 5 points to 98.50 at option expiration in one month. The short out-of-the-money 95-Strike call will lose all time value and will produce an $567 profit. With Mosaic stock trading at 98.50, the intrinsic value of the in-the-money 75-Strike LEAPS option I purchased when Mosaic was trading at 93.50 will increase in value 5.00 points. The short 95-Strike call will have a 3.50 point value and I will have to buy to close the 95-Strike call at 3.50 points. The 75-Strike LEAPS option I purchased has 15.17 points of time value and will lose approximately 1.16 points of time value per month over the 13 month life of the LEAPS option. The net result would be a $601 profit at option expiration in less than one month. This would represent a 21.4% return on the $2,800 cost of the spread.

             Mosaic Stock Closes at 98.50 at option Expiration

Short  95-Strike call              + $567 time value

Long 75-Strike LEAPS call      + $500 increase in intrinsic value

Long 75-Strike LEAPS call       - $116 loss in time value

Short 95-Strike call                - $350 buy to close

                   Net Result       + $601 Profit

$6,804 in Potential Cash Income on a $2,800 Investment

If Mosaic stock is trading at 98.50 at option expiration in January 08, I would ‘buy to close’ the January 08 95-Strike call at 3.50 points and ‘sell to open’ the February 08 at-the-money call which would be the 100-Strike call in this example. The sale of the February 100-Strike call would off-set the cost to ‘buy to close’ the short January 95-Strike call at 3.50 points. At February option expiration, I would sell the March at-the-money call and this process is repeated every month until the LEAPS option expires in January 09. This allows me to sell an additional 12 months of option premium during the life of the LEAPS option. This would result in $6,804 of potential cash income being credited to my brokerage account over the 13 month life of the LEAPS option regardless of the price movement of Mosaic stock. This translates to a 243% potential return on my initial $2,800 investment. If Mosaic stock declines in price an at-the-money call can still be sold each month as long as Mosaic stock does not drop below the strike price of the LEAPS option purchased which would be 75 in this example.

If Mosaic stock decreases 5 points to 88.50 at option expiration, I incur a $49 loss. The short 95-Strike call will expire worthless.

           Mosaic Stock Closes at 88.50 at option Expiration

Short   95-Strike call             + $567 time value

Long 75-Strike LEAPS call       - $500 decrease in intrinsic value

Long 75-Strike LEAPS call       - $116 loss in time value

                   Net Result        - $49 Loss

With Mosaic stock trading at 88.50 at January 08 option expiration I would sell the February 08 at-the-money call which would be the 90-Strike call.

If Mosaic stock is unchanged at 93.50 at January 08 option expiration the spread would realize a $451 profit (16.1% return) and I would sell the February 08 at-the-money call which would be the 95-Strike call. 

Mosaic Stock Closes Unchanged at 93.50 at option Expiration

Short 95-Strike call               + $567 time value

Long 75-Strike LEAPS call       0 no change in intrinsic value

Long 75-Strike LEAPS call       - $116 loss in time value

                   Net Result        + $451 Profit

 Spread Orders

With Mosaic stock trading at 88.50 at January 08 option expiration I would sell the February 08 at-the-money call which would be the 90-Strike call (closest to 88.50 stock price). 

If you call in your orders to your broker, you would enter the type of order below to establish a spread position:

      ‘Buy 10 Mosaic Jan 09 75-Strike calls to open and sell 10 Mosaic Jan 08 95-Strike

     calls to open at a net debit of 28.00 points.’

 By entering a spread limit order I was able to ‘split the difference’ between the ‘bid’ and ‘ask’ prices instead of paying the ‘ask’ price for the LEAPS option and receiving the ‘bid’ price for the short 95-Strike option. This resulted in a net savings of about .80 points per spread.

 Rolling Over Monthly Options

At option expiration each month, I ‘buy to close’ the expiring option and normally ‘sell to open’ the at-the-money call for the new month. This process is repeated every month until the LEAPS option expires.  Selling an at-the-money call provides the premium with the most time value. Selling an in-the-money call provides the most total premium and downside protection in the event the underlying stock declines in price. But an in-the-money call has less time value than an at-the-money call.

           Advantages of Option Income Strategy

     ● Provides excellent monthly returns if the price of the underlying stock increases or is flat

     ● Unlike an option purchase strategy, the Option Income Strategy does not require a large price increase in the underlying stock to be profitable

    ● Sale of short-term option provides downside protection if the underlying stock decreases in price

    ● Sale of short-term option can provide up to a 100% to 150% return over the life of the LEAPS option purchased

    ● If the underlying stock declines in price, a short term at-the-money call can still be sold each month for cash income if the underlying stock does not decline below the strike price of the LEAPS option purchased.

    ● Can provide a high percentage of winning trades even in a flat market

    ● Provides an excellent Reward/Risk Ratio

Excellent Strategy for Profiting in Volatile Markets

The Option Income Strategy is a great way to profit during volatile markets. The strategy is very flexible and can be adjusted for changing market conditions or to fit your personal risk tolerance. For example, in-the-money calls can be sold if you have a short-term bearish outlook for the LEAPS option underlying stock or if you want to incur less risk. Selling in-the-money calls provides more downside protection if the underlying stock declines in price and at the same time can provide an excellent monthly return. 

Out-of-the-money calls can be sold if you have a bullish outlook for the underlying stock. Selling out-of-the-money calls can provide a higher monthly return but provide less downside protection if the underlying stock declines in price.