In today's market there are three main styles of trading. There are traders that buy and sell stocks, those that buy options, and those that sell options. Of course you can use each one as opportunities come up but I've found that my favorite one is selling options. By selling options you can create a steady cash flow using your own money.
A person who buys options is betting a stock will take a specific direction in a certain amount of time and will try to determine how big of a move that stock will make. An option buyer is taking on the biggest amount of risk because although he may be the most leveraged there is a chance his options will go to zero if the stock takes the opposite direction, goes nowhere, or time runs out.
A stock buyer simply buys stock thinking they will go up. There is no other reason to buy a stock except to think it has a catalyst to go up or pays a dividend. Although a stock can go to zero, it is very unlikely if the person purchases a stable business. I would consider stocks to be of moderate to low risk depending on the company purchased.
An option seller sells a contract with an expiration date. The buyer of the option has the right to exercise the option within the time given. If the option is exercised the option buyer will either receive or sell the stock at the strike price agreed upon. An option seller makes money whether a stock goes the opposite way of the options sold, close to the option sold, or nowhere at all. I find option seller to be most closely related to sellers of insurance. They are essentially protecting your downside for a premium in the case of puts.
As I've traded I've come to enjoy selling options instead of buying stocks. Buying options is just to risky for me and when I buy a stock it doesn't always go up. When I sell an option I have time on my side. 80% of options expire worthless. There are many factors that go into selling an option. Depending on how the underlying stock moves the option will trade for a certain amount of premium. The closer to the strike price of the option your selling the more premium you get. There are also other factors that go into the price as well.
Volatility in the market can both raise and lower premium. When people are fearful they tend to rush for protection causing a rapid bid up in option prices. Prices can also rise because of company specific fears such as BP during the oil spill or during earnings because stocks tend to move a lot during that time. Premium is also determined by how far out you sell an option. The farther out in time the more you receive. Selling the most current month yields the most premium annually, but you might want to sell farther out options if the premium is low.
I personally like to sell options on commodity stocks. They offer quite a bit of premium and have good underlying businesses. Although you can sell options on safe and stable companies, the premium is very low. For example Baker Hughes (NYSE:BHI), which is the third largest oil services company, currently has a front month "at the money" option giving you 4.35% premium. Sysco (NYSE:SYY) is a food delivery service company that is considered by some to be a defensive stocks. Currently the front month "at the money" option is offering you 1.85%. "At the money" simply means it is the closest strike price to where the stock is trading that isn't "in the money." Both are stable companies with great businesses but Baker Hughes tends to trade with more volatility.
The benefit of an option seller comes when they are trying to buy a stock at a specific price. If I wanted to purchase Baker Hughes at $40 and it is trading at $40.80, I could either place a limit for my price or sell a put. If I choose to create a limit order, what will happen is if during market hours the stock were to trade at $40 my limit would trigger and the stock would be purchased. The benefit would be that I get the stock at the price I want. The negative would be if the stock were to continue trading lower.
If I were to sell the June expiration $40 put, I would receive $1.74 in premium. If the stock goes in the money, meaning it trades under $40 and I end up receiving the stock anytime between now and the options expiration, my cost basis would be $38.26. This both gives me downside protection and premium up front. The negative is I may never get the stock and it trades up. I get to keep my premium and no one ever got hurt making money. Annualized this is a 52.2% gain.
Using covered calls is another strategy that can be used if you already own at least 100 shares of a stock. Although it can cap your upside, the premium is a good way to buffer or hedge some downside risk. This can also be used on dividend payers to receive both the dividend and the premium.
In conclusion I often find it is always good to move into and out of stocks by selling options. The premium is a great income generator and is a great way to control risk. The act of selling options is not really in itself what would be considered income investing, but its not hard to see how it can fit into one's portfolio.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.