Editor’s Note: Options offer tremendous flexibility and leverage that normal stock trading does not. The basic initial actions you have with a single option is limited to either buy or sell (write) and either a call or a put.

However, since there are so many expiration dates and strike prices to choose from, and you can use combinations of different options, you can create a position with any risk level you wish. Below, I explain how.

Buying vs. Selling

When you buy a call or a put, you are paying a premium (the price of the option) for the chance to get leveraged gains in a relatively short amount of time. For example, someone who bought a call on a prison stock before the election would be very happy today.

The downside to that is because options expire, the value of an option can erode pretty quickly due to time decay. It’s not unusual to suffer a large percentage or even 100% loss if the underlying stock moves against you. If you held an option to expiration and it expires worthless, then you lose the entire premium you paid.

When you write (sell to open) a call or put, you receive a premium in exchange for the risk that the option would be exercised. If exercised, you would have to buy a stock at an above-market price (put) or sell a stock at below-market price (call).

Since you are collecting a premium each time you write an option, the cash comes into your account like a cash dividend would. Thus, in effect options can be used to boost the income generated by your portfolio. If an option expires, as the option writer your profit is 100%.

Writing a Call

Today, for beginners who are interested in using options for income, I will go over the basics of selling a call and selling a put.

When you sell a call, you are giving the counterparty, the person who buys the call from you, the option to buy 100 shares of the underlying from you, per contract, at the strike price at anytime before the expiration date.

If you don’t have any shares of the underlying stock, then you would be selling a naked call. If the call is exercised, you would be forced to buy shares of the stock in the open market to deliver to the option buyer. Since there’s theoretically no ceiling to how high a stock could go, your potential maximum loss is unlimited. This is why naked call is considered to be a dangerous strategy. Your broker may require that you reserve cash when you do a naked call.

By contrast, let’s say you have 75 shares of the underlying stock, then the call is partially covered. You would only need to buy 25 shares on the open market. Even better, if you have enough shares of the stock to cover all contracts, then you have a covered call. The worst case is if the call is exercised and you have to sell your shares at the strike price.

Since you don’t have to buy anything on the open market, then no matter how high-priced the stock became, you don’t need to come up with additional cash to buy it. Thus, a covered call is considered a conservative strategy.

The call buyer would only exercise if the stock is above the option’s strike price, so you would be selling the stock at a below-market price. Therefore, it would make sense to sell a call at a strike price at which you would not mind selling the stock anyway.

Writing a Put

In the case of put selling, the put buyer would not exercise the option unless the stock is below market price, so you would be paying an above-market price for the stock.

It would make sense to sell puts against a stock you like because you could end up owning that stock, especially if you pick a strike price that you would have seriously considered buying the stock anyway.

Put another way, even if you end up having to buy a stock at the strike price, it wouldn’t be the worst thing because you would have bought the stock at that level anyway. When you sell a put, your broker will likely set aside the amount of money needed to buy the stock as a required put reserve. For example, if you sell two $30 puts against a stock, the broker will set aside $6,000 (2 x 100 x $30).

Of course, if you end up buying the stock and it keeps falling then you stand to lose even more money. That’s why it’s worthwhile to do some due diligence on stocks you plan to sell puts against.

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