What Is an Option Income Fund?

An option income fund, also known as an option income closed-end fund (OI-CEF), is a type of pooled investment whose purpose is to create current income for its investors by receiving premiums from the sale of options contracts. Profits through option techniques like as straddles and strangles, as well as from writing covered calls and employing other more complex tactics, can be generated.

THE MOST IMPORTANT TAKEAWAYS

• An option income fund is a closed-end pooled investment that creates profits for investors by selling (writing) options contracts.
• A fund that invests in option income would often adopt lower-risk tactics that can create consistent income streams while minimizing exposure to changes in the direction of the market.
• These investments have the greatest impact in tax-exempt accounts such as Roth IRAs since they generate regular income streams.

Option Income Funds: What You Need to Know

Option income funds are typically best suited for tax-advantaged accounts since the profits made by investors on the options they sell are treated as ordinary income rather than dividends, resulting in lower tax rates. One method by which these funds earn income is by the sale of options methods that are delta-neutral, which means that their value does not vary as the market goes either up or down. A short straddle is an options strategy that involves selling both a call option and a put option with the same strike price and expiration date.

A strangle is similar to a spread, except that it employs calls and puts with different strike prices instead of just one. It is employed when the trader feels that the underlying asset will not move significantly higher or down during the course of the options contracts’ lifespan. The amount of premium earned by writing the options represents the maximum profit. Due to the possibility of a limitless loss if the market swings drastically, this method is normally reserved for more experienced traders.

Another typical strategy is the covered call, in which an upside call is sold against an existing long position in the same underlying. When adopting a covered call strategy, the portfolio might still lose money if the underlying asset’s price declines, and the maximum profit on the upside is also limited. A covered call strategy, on the other hand, can be a reasonably low-risk income producer if the asset’s price remains relatively stable.

Investing in option income funds can reap significant benefits, including better returns than traditional mutual funds. This type of income-generating technique, on the other hand, can be considerably riskier than merely investing in dividend-paying stocks. Because they make use of options contracts, there are a number of additional risks. As a result, there are both supporters and detractors of option income CEFs. A 2005 Bloomberg article titled “Option Income Funds: Watch Out” provides an example of the latter, which argues that while payouts may be generous during low-yield periods, the risks associated with them are significant. 

Advantages of Option Income Funds

In contrast, according to a 2012 article in Kiplinger, “Option-Income CEFs May Be a Smarter Choice.” According to Jeffrey R. Kosnett, there are approximately 30 option-income CEFs, which range from funds that concentrate on just the 30 stocks in the Dow Jones industrials to funds that sell options on emerging-markets equities. He went on to clarify that there are several important advantages to using such funds, including: “Option-income CEFs, regardless of their investment approach, have two characteristics in common. For starters, all of these companies trade at a discount to their net asset value per share. Second, these funds are particularly well suited to a market that is trapped in a relatively tight range of prices.” 

According to Kosnett, the explanation for this has to do with covered-call strategies: “Essentially, a call option offers its holder the right to purchase, or call, a stock from the option’s seller at a predetermined price and by a predetermined deadline. Purchasing options carries a high level of risk. However, selling a call option against a stock that you already own is a prudent move. The potential appreciation of your equities is limited as a result of this strategy, but you generate additional revenue through the sale of the options.”

Kosnett went on to say the following:

Option-income funds describe a large portion of their payouts as a “return of capital,” which implies that you are not receiving a legitimate dividend. As with good cholesterol and bad cholesterol, there are good and terrible returns on capital, just as there are good and bad returns on investments. The cash inflows from option sales are predictable and long-term.

Mack Capital’s founder and investment team have a wealth of knowledge and experience in the financial industry. Because of our unique and inventive approach to the capital and private equity markets, you can be assured that your money is constantly working hard to benefit you and your business. A comprehensive full-service financial planning firm is formed when Mack Capital and our general partner, M&A Wealth, come together to form a partnership. Financial planning, investment guidance, possibilities, and value-creation strategies are all provided by these two enterprises, which work together to benefit both businesses and individuals.