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By Chris McKhann

"Income generation" is one of the foremost uses for options.

The covered call trade, where calls are sold against long stock to collect the options premiums, is the most widely used option strategy by far. Compared to the income that can be had from savings accounts, CDs, or bonds, the income from selling options can be particularly attractive--but it does come with some potential downside.

The Wall Street Journal recently ran an interesting article on funds that are using options to generate income on their positions. The funds mentioned in the article use a variety of strategies.

Some own a portfolio that mimics the S&P 500 and sell index calls against it. Some also buy puts to protect the downside in a collar strategy, though most apparently don't do all the time. Some buy dividend-paying stocks and sell calls against them.

There are also differences in what expirations are used and how far out of the money they are. Some sell calls against all of their holding, while others don't sell as many to maintain more potential upside for their positions.

BXMA covered call portfolio will outperform a stock portfolio in all but the most bullish markets. Most funds sell out-of-the-money calls against their dividend-playing stocks or on the indexes. The premiums generated create additional gains if the underlying shares remain unchanged and create a cushion, albeit a small one, to the downside. If the stock rises above the strike price, the seller faces the prospect of having to sell their shares. (See our Education section)

I find both the strategy and the returns of these funds interesting. Most of these funds have an average return of 1-2 percent in the last three years (though the article doesn't state when that return period ends). And while covered calls may be the most popular option trade, it isn't necessarily the most efficient.

One of the best ways of looking more generally at the strategy is through the CBOE BuyWrite Index. Over the long term--including the crash of 1987 and the 2008 crisis, this index outperforms the S&P 500 with less volatility. However, the CBOE PutWrite Index is an even better performer, having higher returns and lower standard deviation (the measure of volatility).

Put selling is considered very aggressive and risky, but ultimately it brings better returns and carries lower risk than just owning stock or selling covered calls. The profit-and-loss diagram of a covered call and a short put are essentially the same, but there are clearly some small efficiencies captured in selling puts.

Moreover, short puts generate additional cash in the form of less margin, so more cash can be invested in Treasuries to boost your return. You do forgo the dividends of those stocks, but it doesn't seem to matter that much in the returns for most of these funds.

There is talk in the hedge-fund world of "alternative beta." For a long time volatility sellers, like those who sell covered calls or short puts, considered those returns to be "alpha," or risk-adjusted returns above the benchmark. But what most of these funds provide is "alternative beta," or returns in line with the benchmark (in this case the BuyWrite or PutWrite indexes) and nothing more.

So there are a fair amount of funds out there that are doing covered calls, and a couple of them are really doing them well. But you pay for that service and all of the analysis that goes into such stock and option picking.

You would likely do just as well selling index puts every month or finding a fund that does that for you, if you can.

Source: How to Generate Income on Positions