In the investment section of my net worth reviews, I often shared and discussed how I generate extra passive incomes with options. From time to time, I would receive reader emails requesting for book recommendations or trading strategies. With quite a few requests, I thought that it would be a good idea to create a beginner’s guide to generate extra passive incomes with options for my readers to explore.

My Main Options Strategies

I have two main strategies that I use to generate extra incomes with options on an ongoing basis. The first strategy is to sell covered call options for the stocks that I already own. The second is to sell naked put options for the stocks that I want to own.
 

If you’re not familiar with my options trading strategies, don’t panic. I’ll walk you through all the basics. I’ll break down this topic into a series of three posts.
 

For this post, I’ll cover all the basics and fundamental questions on how to generate extra passive incomes with options. The second post will cover everything specific to covered call options. The third post will cover all the nitty-gritty details related to naked put options.

How do options work?

An option is a contract which gives the purchaser the right, but not the obligation, to buy or sell an underlying asset or instrument like a stock. The option owner/holder can purchase/sell the underlying asset at a specified strike price on a specified date, depending on the form of the option.

Who are involved in an options transaction?

There are usually two parties involved in an options transaction – the writer and the purchaser. The writer is the party that offers the purchaser the right to buy or sell the underlying asset to the writer. The purchaser is the party that buys the right to buy or sell the underlying asset to the writer. For that privilege, the purchaser will have to pay the writer a non-refundable fee called a premium.

What are the types of options?

There are many different types of options that can be traded and these can be categorized in a number of ways. In a very broad sense, there are two main types of options: calls and puts. Call options give the purchaser the right to buy the underlying asset, while put options give the buyer the right to sell the underlying asset.

How do you trade in options?

When you purchase an option, you’re purchasing a contract to buy or sell a stock, usually 100 shares of the stock per contract, at a pre-negotiated price (strike price) by a certain date (expiry date). On the other hand, you can also be the writer and sell the options.

How much is an option?

Let’s say that on August 08, 2018, the stock price of Apple Inc. (AAPL) is traded at about $208/share and the premium (cost) is $3.67/share for a January 2019, $230 Call, which indicates that the expiration is the third Friday of January 2019 and the strike price is $230/share. The total price of the contract is $3.67/share x 100 shares = $367. This is the premium that the purchaser needs to pay the writer for the right to buy 100 shares of Apple Inc. at $230/share during any time before the expiry date.

What type of account do you need to trade options?

To buy option contracts, you only need a regular trading account. To sell (or write) covered call options, you only need to own the stock and have a regular trading account. To sell (or write) naked put options, you’ll need a margin account with the ability to short securities.
 

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What is the time value of an option?

An option’s time value is equal to its premium (the cost of the option) minus its intrinsic value (the difference between the strike price and the price of the current stock). As a general rule, the more time that remains until expiration, the greater the time value of the option.

Why would you buy a put option?

There are two main reasons why you would want to buy a put options. You either want to limit your losses or lock in your gains in case the underlying stock price falls significantly.
 

For example, if you just decided to invest in a volatile stock like Tesla Inc. (TSLA), and want to limit your downside risk, you’ll buy a put options. The price of the stock as of this writing is around $350/share. If you buy a TSLA January 2019, $350 put option, the most that you can lose is the premium that you paid for from now till the third Friday of January 2019.
 

On The other hand, if you already owned Tesla for a while now and had some significant gains, you want to protect those gains. You can buy a TSLA January 2019, $350 put options. You’ll be able to secure some of your gains from now till the third Friday of January 2019 without selling the stock. You’ll still get all the upside if the stock goes up significantly for both examples.

Why would you buy a call option?

There are two main reasons why you would want to buy a call options. You either want to limit your exposure to a stock or maximize your gains without fully committing your investment capital yet.
 

Once again, let’s go back to the Tesla example. Since it’s such a volatile stock and a pretty high price per share, buying a call option would require only a few thousand dollars versus a $35,000 investment for a hundred shares. If Tesla drops significantly, you’ll only lose the premium and nothing more.
 

On the other hand, if Tesla’s stock value increases significantly, your investment return will be magnified. For a fraction of the initial investment, you can experience the appreciation of the full value (minus the premium) of 100 shares of the Tesla stock.

Why would you sell a covered call or naked put options?

The short answer is to make generate extra passive incomes, which I will go into more details in subsequent posts. The other answer is this type of income is very tax efficient as it’s treated as capital gain. Hence, only 50% of the gains are subjected to income tax and keeping more money in your pocket.

What’s an out of the money (OTM) options?

Out of the money options is a term used to describe a call option with a higher strike price than the market price of the underlying asset. For example, if you hold a January 2019, $230 Call options for Apple Inc., it’s out of the money because the strike price ($230/share) is higher than the current price $208/share.
 

OTM options can also be used to describe a put options with a strike price that is lower than the market price. For example, if you hold a January 2019, $200 Put options for Apple Inc., it’s out of the money because the strike price ($200/share) is lower than the current price $208/share.
 

For out of the money options, it’s usually left to expire worthlessly. In this case, the purchaser of the options will lose the premium paid for the option. The writer will make a profit equivalent to the premium minus commission.

What’s an in the money (ITM) options?

In the money (ITM) options is a term used to describe a call option with a lower strike price than the market price of the underlying asset. For example, if you hold a January 2019, $190 Call options for Apple Inc., it’s in the money because the strike price ($190/share) is lower than the current price $208/share. If you exercise the call options, you’ll have a potential gain of the difference between the market and strike price.
 

ITM can also be used to describe a put option with a higher strike price than the market price. For example, if you hold a January 2019, $250 Put options for Apple Inc., it’s in the money because the strike price ($250/share) is higher than the current price of $208/share. If you exercise the put options, you’ll have a potential gain of the difference between the strike and market price.

My Two Cents

With any types of investments, it’s best to learn all the basic fundamentals to ensure that you understand the risks involved. Only invest in assets that you have a full understanding of and not take more risk than you can accept. With that said, every sources of passive income that you can add to your repertoire, the easier it is for you to achieve financial independence and security.
 

So readers, with this would you consider adding another source of passive income with options trading to our other sources of income? Does this guide help you better understand options?