jmkeynes

The Nature of Risk

One way to use options to reduce risk (volatility) is to own an index (e.g. by owning an ETF like IWM) and sell short-term, out-of-the-money, covered call options against that index.

Usually short term (one month or less), out-of-the-money options expire worthless unless the value of your underling investment (e.g. IWM) goes up dramatically. The worst case scenario is that you suffer an "opportunity cost" of not gaining everything that you would have gained if you didn't sell the options. This happens if the price of the underlying index goes up past the strike price on the options you've sold. Your underlying investment gets "called away" but you get paid the strike price and you make money some money from the sale of the options as well.

Generally what happens is that you make some money from the sale of the options. Your investment in IWM either goes down, stays the same, or goes up a bit but doesn't cross the strike price.