For many investors, options are scary. These investors have heard horror stories about people who got burned trading options, or that they're complicated, or that they're not for the little guy.

There are complex options strategies, and people do lose money when they speculate (there are also many investors who make money) with options. Most people who lose money trading options do so because they buy options. In a moment, I'm going to show you how to be the seller, the person who is more often on the winning side of the trade.

The strategy that I'm going to show you is simple, carries no risk to your principal (only opportunity risk), and can boost your returns by double digits annually.

First let's go over definitions of the two kinds of options: puts and calls.

Let's look at an example.

Shares of Microsoft are trading at $26. In July, an investor buys the January $30 call for $1. This means the call buyer has the right (but not the obligation) to demand the shares of Microsoft at $30 from the call seller at any time between now and the third Friday in January. (Options typically expire on the Saturday following the third Friday of the month. The third Friday of the month is the last day the options can be traded.) That $30 price is called the strike price—the price at which the seller of the call agrees to sell the stock to the buyer if demanded.

Why would someone want to enter into a contract to buy shares of Microsoft at $30 in the future if today he can buy them at $26? Because he thinks that by January, the stock is going to be higher than $30. Maybe he thinks it will be $35 by then, and to secure the right to buy it at $30, it will only cost $1.

If Microsoft is above $30 by January, the call buyer can demand the stock at $30, or he can sell the call at a profit. If the stock is trading at $35, he should be able to sell the call for at least $5, turning his $1 per share investment into $5.

Buying the call allows him to participate in Microsoft's upside while risking only $1 per share instead of $26. However, unlike owning Microsoft shares, the call option has an expiration date.

If the stock does not go above $30, the call expires worthless, and the seller of the call keeps the $1.

Puts act the same way, only the buyer of the put has the right (but not the obligation) to sell the stock at a certain price. If an investor owns Microsoft at $26, she may buy a $24 put to limit her losses.

If tomorrow it's discovered that Microsoft's code has been secretly stealing the personal information from every PC user in the world, the government shuts the company down, and the stock falls to zero, the buyer of the put can force the seller to buy her shares at $24.

Buying a put on a stock you own is like buying insurance. You hope to never need it but are glad you have it if you do. However, puts aren't right for everyone. If the price of a put costs 10% of the amount you invested in the stock, and the put expires in 6 months, you'll have to determine whether it's worth it to give up 10% to mitigate the risk.

If you want to learn all about options and strategies, there are tons of books on the subject, including Get Rich with Options by my friend and colleague Lee Lowell.

Covered Calls: The Espresso of Income Investing

Investing in dividend stocks is like a good strong cup of coffee for your portfolio. It puts some giddyap in your finances and helps you achieve your goals. Just like a cup of coffee gives you a jump start in the morning.

Some people need a little bit more help, particularly in the afternoon or maybe at night if they're going out. So rather than a cup of regular coffee, they kick it into overdrive and order an espresso.

A regular cup of coffee really doesn't do much for me. A shot of espresso, however, is like rocket fuel. I'm raring to go.

That's what a covered call is to your portfolio. It's like a shot of espresso to increase your returns.

When an investor sells a covered call, he already owns the stock he is selling the call against, and agrees to sell the stock to the call buyer at the strike price (the specified price) by a certain date if the call buyer demands it.

So going back to our Microsoft example, if you own the stock at $26 and sell the January $30 (the strike price) call for $1 (per share), you will have to sell your stock to the call buyer for $30 by the third Friday in January if she exercises the contract (demands it).

Let's assume that it is July, so January is six months away. Let's look at some scenarios.

• Best-case scenario. Microsoft stock trades up to $29.99 at expiration (third Friday in January). The call expires worthless and you keep the $1 per share. You've earned two dividend payments of $0.28 each for a total of $0.56. The stock is also up $3.99 since you bought it.

• Worst-case scenario. It is discovered that Microsoft has been cooking its books for years, Bill Gates and the rest of the executives go to prison and the stock falls to zero. You'll at least get $1 out of the deal, as you'll keep the $1 from the now-worthless call. The call is worthless because no one is going to force you to sell a stock to him for $30, when the price of the stock is below $30.

  The $1 helps protect the investor from some downside. And if you're a long-term investor, particularly if you're interested in the dividend or reinvesting the dividend, the stock's decline doesn't matter much to you. It matters only when you're ready to sell. In the meantime, if the stock slips to $23, you're still reinvesting the dividends at a lower price, and, oh, yeah, you get to keep the $1 per share, which is equivalent to another 3.8%.

• Annoying scenario. Microsoft trades up to $33. Your call buyer can exercise her option forcing you to sell your shares to her for $30. Don't forget, you'll also keep the $1 she paid you, so it's like you're selling it for $31. Even though the stock is 7 points higher, you still made $5 ($4 profit plus $1 for the call) on a $26 stock in 6 months, or 19.2%, so it's not the end of the world.

But you did miss out on greater profits, which is the risk when you sell a call. Imagine if you made the same transaction, but instead, Apple bought Microsoft for $50 per share. You'd be a little more annoyed that you were missing out on all that extra profit.

As I've said repeatedly, there's no such thing as a free lunch on Wall Street. If you're going to make an easy $1 per share by selling a call, you're taking on the risk that you'll have to sell your stock at a lower price than where it might trade in the future.

That doesn't mean you'll suffer a loss, though. Let's be very clear about that. If you sell a call at a strike price that is higher than the price you paid for the stock, you cannot suffer a loss as a result of the call being exercised. That's an important concept to understand.

You can, of course, suffer a loss if the stock goes lower and you sell it. But selling a call with a strike price above what you paid for the stock cannot result in a loss to you, only a loss of opportunity if the stock goes higher than your strike price.

Even if the stock price is above the strike of the call you sold, you don't always have to sell your stock. If Microsoft is trading at $33 and you've sold the January $30 call, rather than selling your stock, you can buy back the call, albeit at a loss. So perhaps you'll have to pay $3.50 for the call that you sold for $1, incurring a loss of $2.50 per share. But you may determine that it's worth it if you own the stock, are reinvesting the dividends, and are building up a nest egg.

Or you may even be able to buy back the call at a profit. The values of options decay as the expiration date gets closer. If Microsoft is trading at $30.25 the day before expiration, you may be able to buy back the calls at $0.50, in which case you get to keep your stock and still make a $0.50 profit on the call that you originally sold for $1.

Option Prices

A few key variables affect option prices. They include how far away the stock is from the strike price, time, and volatility.

An in-the-money call option is a call whose strike price is below the current stock price.

Example: Freeport-McMoRan (NYSE: FCX) is trading at $37. A January $35 call is in the money because the strike price ($35) is below the current price ($37). The option is currently trading at $8. That's because the stock is already $2 in the money. The call has to be worth at least $2, because that's the profit an owner of the stock could make automatically upon purchase of the stock at $35. The remaining $6 is because of volatility, which we'll talk about in a moment.

If you were to sell the January $37 call, it would be at the money, because the current price and the strike price are the same. That call goes for $7, all of which is because of volatility. Someone who exercised the option and bought the stock at $37 would not have a gain or loss with the stock trading at the same price.

The January $40 call is out of the money because the $40 strike is above the current price of $37. The $40 strike will cost you $5.75, again all of which is because of volatility.

So now let's talk about volatility.

Volatility: An Option Seller's Best Friend

If you sell calls against your stocks, forget the family dog; volatility is your best friend. Volatility is a measure of how much the price of a stock fluctuates. The more the stock price bounces around, the more likely an option's strike price will be met, which is why stocks that are more volatile have higher-priced options.

Think of it this way: If you are buying an option that has very little chance of actually hitting the strike price, you probably won't be willing to pay very much for it. But if a stock is up three points one day, down six the next, up five the following day, and so on, there's a better chance your option will hit the strike price and become profitable. Because of the better odds, you will have to pay a higher price.

There have been many studies on volatility, and you can read all about it in various books about options. But I wanted to give you a simple explanation.

Transocean Limited (NYSE: RIG) happens to be a very volatile stock because it tends to react to price swings in oil. Another stock, such as B&G Foods (NYSE: BGS), might be in a similar price range, but its options are much cheaper because the stock isn't as volatile.

When you sell calls on volatile stocks, you collect a bigger payment from the buyer. The fact that it's more volatile increases the chance that your call could be exercised and you'll have to surrender your stock, but you're getting paid well to take that risk.

For example, if you bought Transocean at $21 and in late November 2014 sold the January 2016 $25 calls for $2.00, you'd make 9.5% on your money just from the calls alone ($2.00 divided by $21). If you owned the stock for a year while you're waiting for expiration of the call, you'd get paid another $3 in dividends (Transocean has an exceptionally high dividend), increasing your return to 23.8%. Finally, if the stock is above $25 and gets called away from you, you'd make 42.9% in 1 year.

Of course, the risk is that the stock is trading at $40 and you have to sell it for $25. But the fact that you made $3.00 in dividends plus $2.00 from the call, can take away some of the pain of the missed opportunity.

Plus, if the stock goes against you and falls to $20, you're still in the black because you collected the $2.00 from the call and the $3.00 in dividends. The call essentially lowers your break-even price from $21 to $18.

Time Is on Your Side

Time is the other component in an option's price. The longer the amount of time until expiration, the more the option will be worth. It makes sense. After all, the further away expiration is, the more time the stock has to hit the strike price. A stock with an option that expires in just a few weeks may have little chance of hitting an out-of-the-money strike price. Therefore, it would be very inexpensive.

Option prices decay with time. If a stock never moved a penny from the time you sold an option on it, you would see the option price slowly fall with the passage of time. As the expiration date gets closer, the price decline picks up momentum.

That's why I say time is on your side as a call seller. If you sell a call for a nice price, eventually the time component of the price will deteriorate. The option price could go higher if the stock gets more volatile or if the stock price climbs, but the time element will dwindle to zero like the sand in an hourglass.

In fact, it's possible you could sell an out-of-the-money call, see the stock rise to go in the money, and still make a profit.

Here's how.

In our Transcoean example, with the stock trading at $21 in November 2014, you sell the January 2016 $25 call for $2.00. In late December 2015, the stock is trading at $26. Because so much time has expired over the life of the option contract, there is very little time value left. So the January $25 call, which you sold for $2.00, may now be trading at $1.50, even though the stock is $1 in the money.

You could buy back the call for a profit of $0.50 ($2.00 – $1.50) and hang on to your stock, which is now trading at $26.

Who Should Sell Covered Calls?

Because the seller of the covered call may have to give up his stock, this strategy is more appropriate for investors who are seeking current income as opposed to those who are trying to build wealth via dividend reinvestment.

If you're trying to build a nest egg with a time horizon of 10 years, by reinvesting dividends, chances are that within those 10 years, we'll hit a bull market, stocks will rise, and any stock you sold covered calls against will be called away from you, disrupting the compounding dividend machine.

Of course, you could always take the money from the sale of the stock and put it into another dividend payer. But one of the appealing aspects of the dividend reinvestment method is how easy it is and how little time you have to devote to it.

Also, there is no way of automatically reinvesting the money you receive from selling the calls back into the stock. That's not a huge problem, but buying more stock with the money you receive from the calls is another step you'd have to take if you were trying to build up your holdings in that particular stock.

If you're selling covered calls against your position, you definitely want to be on top of it.

But the time commitment can certainly be worth it. If you're looking for current income, this is a terrific strategy to boost your returns. As you saw in the Transocean example, if the stock gets called away from you at $25, you'd have earned 42.9% instead of 33.3% from the dividends and price appreciation. If you weren't forced to sell the stock, you'd have earned an extra nearly 10% on a stock you were planning on hanging on to anyway to receive the dividend.

And if the stock gets called away from you, just take your gains and move on to the next dividend stock.

The only real downside is when the stock flies way past the strike price. That can be frustrating as you miss out on those additional profits. And chances are if you sell enough covered calls, it will happen to you. But over the long haul, it's worth putting in the extra time to manage your positions to get those extra double-digit returns year in and year out on your stocks.

Now, what happens if your stock takes a dive and you want to dump it but you sold a call against it? No problem, you just buy the call back, usually much cheaper. If Transocean falls to $18, your $25 call will likely fall right along with it. The decline of the call won't match that of the stock dollar for dollar, because, remember, an option's price is also made up of time and volatility components. But it should be lower, and you can buy back the call at a profit and then sell your stock.

For example, if you sell the Transocean $25 calls for $2.00 and the stock drops to $18, the option may be trading at $0.75. You'd buy it back and profit $1.25 ($2.00 – $0.75). The $1.25 profit on the calls offset some of the $3 loss on the stock.

Espresso isn't for everyone. Some people get jittery from all that caffeine. But others love the extra lift it provides. Covered calls are similar. Some investors don't want to commit the extra time to studying and managing their options positions. But for those who do, the extra boost to their portfolio's returns can be grande (sorry, I couldn't resist).

20% Annual Returns

There are various strategies for selling covered calls. Some investors like to sell out-of-the-money calls, accepting less premium for their calls to decrease the chances that the stock will be called away.

Others will sell in-the-money calls so that they maximize the income they collect from the calls and don't care if the stock is called away, even at a loss because the higher option premium will make up for it. This can also be an effective strategy in a bear market because if the stock falls, you may still keep your stock and you've collected the higher option premium.

Both of those strategies are effective, and the choice simply depends on what your priorities are in using covered calls and your market outlook. I tend to go right in the middle of those two strategies.

The method that I most often use and recommend is short term in nature and uses at-the-money or slightly out-of-the-money calls.

If I'm selling a covered call, I'm renting the stock, not buying to own. In other words, I don't care if the stock is called away from me. In fact, all the stock is to me is a vehicle for producing income. It's not something I'm planning to own for the long term. I don't care how good or bad management is, whether the company generates plenty of cash flow, or whether margins are increasing.

It is simply a three- or four-letter ticker symbol that will generate enough income for me to reach my goals.

What are my goals? I'm glad you asked. When selling covered calls, I'm trying to achieve 20% annualized returns.

If I can achieve a 3% or more return in 6 weeks, annualized that comes out to 26%. To achieve the 3% return, I need a combination of a dividend payment and option premium. If I make a little bit on the stock, that's just gravy.

Here's what I mean.

Let's say in the middle of September, International Paper (NYSE: IP) is trading at $48.25. The November $49 call can be sold for $1.30. The stock pays a $0.35 per share dividend in mid-November.

I buy International Paper for $48.25 and sell the November $49 call for $1.30. Before expiration I collect the $0.35 dividend. At expiration, one of three scenarios will have occurred:

• The stock is above our strike price of $49.
• The stock is at our strike price of $49.
• The stock is below our strike price of $49.

Let's look at the first scenario—the stock is above our strike price of $49.

November rolls around and International Paper shares have been strong. It's the third Friday in November (the last day you can trade an option before expiration) and International Paper is trading at $52.

If you do nothing, the stock will be called away from you, meaning you'll have to sell it at the agreed-upon price (strike price) of $49. You would keep the $1.30 option premium, the $0.35 dividend and the $0.75 capital gain (you bought the stock at $48.25 and sold it at $49 for a $0.75 gain). In total, you made $2.40 on the covered call or 5% ($2.40/48.25 = 0.05).

You may think 5% is nothing special, but remember, you made that in two months. Considering the average return on the stock market is about 8% for the entire year, 5% in 2 months is pretty strong. Annualized that 5% turns into 30% (12 months divided by 2 months equals 6. 6 × 5% = 30%).

If you decide you'd rather keep the stock because you think it's going higher, you could buy back the option so that your stock isn't called away from you. Because the stock is $3 higher than the strike price, you may pay $3.10 for the option.

In that case, you lost $1.80 on the option (sold it for $1.30 and bought it for $3.10) and made $0.35 on the dividend. You now have a $3.75 open gain on the stock, which you can sell at a later date, hopefully for a larger gain.

When the stock is right at the strike price or when the stock is below the strike price, your option will expire worthless. Technically, the buyer of the call can call your stock away; however, if it were trading right at $49, the call buyer would likely be better off just buying the stock in the open market. Commissions are usually higher for calling away a stock or having a stock called away versus buying or selling in the open market.

So if the call expires worthless, as the seller, you keep the premium and the stock.

Keep in mind that if the stock drops significantly, you can still be down a meaningful amount. If International Paper drops to $40 per share, yes, you still keep the $1.30 option premium for selling the call and the $0.35 dividend, but you're down $8.25 on the stock. If the stock falls hard and it isn't a long-term holding, at some point, you may decide to sell the stock for a loss and buy back the call at a gain.

If the stock drops to $40, the option will be essentially worthless because no one will buy your stock from you at $49 if it's trading at $40; you'll be able to buy back the call, perhaps for as little as $0.05.

If the stock were trading at $47 and there were still several weeks to go before expiration, you might be able to buy back the call at $0.50, making $0.80 on the option, but still be down $1.25 on paper.

When selling covered calls, I try to capture that 3% to 5% in 6 to 8 weeks. If I can generate those kinds of returns each trade and make those trades throughout the year, I should have no problem earning 20% on my money.

Of course, the market and the stocks have to cooperate. If there is a big correction or downturn in the market, it won't be as easy. On the other hand, selling a covered call on a quality dividend payer is a way to generate some extra income during a slide in the market.

The strategy for doing this is to sell at-the-money or slightly out-of-the-money calls on stocks whose ex-dividend dates are before the option expiration.

In the International Paper example, the stock's ex-dividend date was in mid-November and we sold a November call, which expired about a week after the stock's ex-dividend date.

That allows us to capture both the dividend and option premium if everything goes according to plan. But sometimes plans don't work the way you expect.

If the stock is above the strike price before the ex-dividend date, the call buyer might call the stock away from you to receive the dividend.

So if International Paper is trading at $52 in mid-November, the call buyer might exercise the option and call the stock away from you at $49. He buys the stock below the current market price and will be entitled to the dividend because he now owns it before the ex-dividend date.

As the option seller, you keep the full $1.30 option premium and sell the stock for $49, pocketing $0.75 per share. In total, you'd make $2.05 or 4.2% in less than 2 months—which still comes out to well over 20% annualized.

If over the course of the year, you made this trade over and over again, never being able to capture the dividend—just the option premium and the small gain on the stock, you'd still make more than 20% on your money.

Investors who use covered calls can also sell calls several months or even years out to get more option premium. In addition, they can sell calls that have a strike price that is much lower than the current price (deep in-the-money calls), for which they will receive more premium or much higher than the current price. In the latter case, they'll receive much less option premium but can capture more gains on the stock if it goes up.

Selling covered calls is a great way to generate short-term income, and you can do it in most individual retirement accounts. The risk, like with any stock, is that the stock goes down. You still get to keep the option premium and dividends, but there is still stock market risk. There is also opportunity risk in that you won't get to participate in endless upside on the stock. The gains are limited by the strike price.

But that's okay, because we're not entering this type of trade to try to hit a home run on the stock. We're trying to generate extra income.

Selling Puts

Some investors are big fans of selling naked puts. Unlike an out-of-the-money covered call in which you already own the security and you can't lose any money unless the stock price goes down, selling a naked put involves significant risk. The strategy is called naked because the option is not married to a stock. If you were short the stock and sold the put, it would not be naked.

When you sell a put, the buyer has the right to sell you the stock at the strike price before or at expiration. Therefore, when you sell a put, you need to be prepared to buy the stock.

Put sellers typically sell out-of-the-money puts—a strike price below the current market price.

In return, you receive the cash that the buyer pays for the put. If the stock does not reach the put's strike price, you keep the cash. If the put does wind up in the money, you may be forced to buy the stock, which can get expensive.

Think of it this way; the put buyer is purchasing insurance on her stock. If the stock price goes down, she is protected by the puts. You, as the put seller, are the insurance company. You collect and keep the insurance premium and take on the risk if something goes wrong.

Let's say Merck (NYSE: MRK) is trading at $60, and you sell 5 puts on Merck with a strike price of $55 for $1 per contract. Since option contracts represent 100 shares, you'll receive $100 per contract, or $500. If the Merck puts are in the money (below $55) and you are required to buy the stock, you will need to pay $27,750 (500 shares × $55 per share).

Investors who sell naked puts should do so only if they want to own the underlying stock at the strike price where the puts are sold. They also need to have the money available to purchase the stock if it is put (sold) to them.

Put sellers love this strategy because, in a bull market, it's like free money. They collect the cash from selling the puts and are not required to own any stock. (However, they don't participate in any upside if the stock goes higher.) If the stock slides, they not only keep the cash but also buy shares at a lower price than they would have earlier.

Using our Merck example, if Merck is trading at $60, an investor sells the puts with a $55 strike, and the stock is put to him at $55, the net cost will be $54. Don't forget, he received the $1 per share for selling the put. When Merck was trading at $60, if the investor would have been happy to own the stock at $54, the trade might be attractive.

The risk is that Merck could be sharply lower by the time the option expires. If one of Merck's drugs is shown to have nasty side effects and the stock slides to $50, the put seller is still on the hook to buy it at $55. Like the covered call, you can always buy the put back at a loss if the trade goes against you—before the stock is put to you.

A put-selling strategy is appealing to dividend investors who see a stock they want to buy but feel it's overpriced. They can sell the put and essentially be paid to wait to see if the stock price comes down. If it does, the investor can get the price she wants. If not, at least she collected some income during the process.

This can be an effective way of ensuring that you're buying low. When stock prices are rising and valuations are increasing, the put seller does not buy stock, but simply collects cash from the option premium. Then, when there is a correction or the stock falls, he is right there to scoop it up on the cheap.

Considering most investors put money to work at the wrong time—after the markets have gone considerably higher and take money out when markets fall, this is an effective strategy to ensure you're investing at the right time—when prices are low—and getting paid to wait until the time is right.

The risk comes from the possibility that you buy a stock much higher than it's currently worth.

In our Merck example, if the company reports a horrendous quarter and announces it has to pull its biggest-selling drug off the market because it turned out that instead of curing people, it was killing them, the stock might drop to $25. The put seller now owns a $25 stock at $55, where he was forced to buy it.

While I like put selling, it's more complicated than selling covered calls. For most investors, the covered call strategy is a better one for a very important reason: The risk is lower. The last thing you want to do when you're conservatively investing for income and for the future is to get blown up by an options trade.

When you write covered calls, other than your stock going down (which could happen regardless of selling calls), the worst that could happen is that your stock takes off and you're forced to sell it and miss out on some upside, or you sell the calls at a loss to keep the gains in the stock.

Summary

• Selling a covered call is a great way to boost the income you receive from your stock holdings.
• When you sell a covered call, it gives the buyer the right, but not the obligation, to buy your stock from you at a specified price (strike price) by a certain date (expiration date).
• When you sell an out-of-the-money covered call, your only risk is opportunity risk (although you can choose to buy the call back at a loss if you don't want to give up your stock).
• You need to actively monitor your covered call positions. A covered call strategy requires more attention by you, so you're no longer snoozing your way to wealth.
• Selling out-of-the-money, naked puts allows you to get paid to wait and see whether a stock you're interested in comes down in price, but it carries more risk than covered calls.
• Coffee doesn't do a thing for me. Espresso, however, turns me into Jim Carrey on uppers.