In the investing world, generating income typically refers to slow, predictable payments from an investment over time. It may be a stock paying dividends or a bond with coupon payments. With options, generating income usually refers to selling options and collecting premium from option buyers.
The most common income generating strategy using options is the covered call. Well, technically a covered call includes a stock and an option. By selling a call against long stock you could potentially earn income from the stock (dividend payments) and the short option (premium). The two-fold income generation of a covered call strategy is one of the reasons it’s so widely used.
Of course, there are many different way you can generate income from options strategies. An options income strategy can range from obscenely complex to super simple. Covered calls are generally considered simple, though they can be utilized in a more complex fashion if you choose.
Another income generating strategy used mostly by institutions is the short straddle. A short straddle is when a trader sells a call and put at the same strike in the same expiration. This trade is used when the seller believes the underlying asset is going to remain in a certain trading range.
Now, retail and smaller traders should never sell a straddle. It’s too risky and margin requirements are too high. However, seeing what straddles are being sold by the big players can be a good way to analyze assets.
For instance, if a bunch of short straddles trade in a certain stock or ETF, then someone with a lot of money believes that asset will be range-bound until expiration. In fact, this just recently occurred in the Utilities Select Sector SPDR ETF (NYSE: XLU).
Utilities are already known to be a slow moving asset. So, if someone with big bucks is selling straddles in utilities, you can bet the range is going to be extremely tight. In this case, the straddles don’t expire until January of 2019 – so utilities may remain in a narrow range for all of 2018.
To be specific, with XLU at around $56, the trader sold 1,100 of the January 2019 56 straddles for $7.37 per straddle. The trader collects over $800,000 on the trade and keeps it if XLU remains between roughly $48 and $64.
Okay, so this trade is not for the average investor – like I said, margin requirements would be insane. However, it really isn’t that risky. XLU doesn’t move that much to begin with and the trader has a very wide range to work with. The chance that utilities go crazy or collapse is basically zero. That’s not to say this trade is a guaranteed winner – not by any stretch – but I get what the trader is thinking.
If this trade idea appeals to you but you don’t want the risk or the margin requirements, you can pretty easily solve the situation by purchasing a call and put outside the short straddle. (In other words, go long an options strangle.)
Let’s say you purchased the 47 put for $1.25 and the 65 call for $0.50 in the January 2019 expiration. You’ve capped your risk (and your margin needed) and it only cost you $1.75 (off the $7.37 from the short straddle). So you’re still making decent money but you’ve substantially cut your risk. By the way, this short straddle surrounded by a long strangle has a name… the iron butterfly, and it’s a fairly popular strategy to use.