As many of you know I am a trader turned into a dividend growth investor. I have a little more free time on my hands these days, so I decided to bring back some of my old trading strategies to hopefully generate extra income to fund my two stock portfolios – the Dividend Empire and the Freedom Fund.
The strategies that I have employed this year include options, day trading, swing trading and peer to peer lending. I gave brief introductions to these strategies in a previous post, but didn’t get a chance to really do them justice.
This post will be the first of a series describing, in detail, the various strategies I am using to boost my income. I will begin with a strategy very well suited for dividend growth investors, and one that can generate big monthly income: selling options for income.
In this section I am going to cover just enough about options to understand my strategy. If you want to learn more or have any questions feel free to contact me at firstname.lastname@example.org. You can also do some simple Google searches on options to uncover a wealth of information. If you already know the basics, go ahead and skip down to the strategy.
While there are many different strategies that use options, even the most complex are based on the simple purchase or sale of call and put contracts (or combinations of both). Luckily, for this strategy you only need a good understanding of these basic contracts and we don’t have to get into more complex strategies.
Calls & Puts
A call contract gives its owner the right to purchase 100 shares of an underlying stock at a predetermined price (the strike) prior to the expiration date of the contract.
A put contract gives its owner the right to sell 100 shares of an underlying stock at a predetermined price (the strike) prior to the expiration date of the contract.
Example call contract: AAPL Oct 21 2016 $110 Call
Contract Details (actual values on 8/30/2016):
- Underlying stock: Apple (AAPL)
- Expiration date: October 21, 2016
- Strike Price: $110
- Premium: $1.50
You could purchase this contract for $150 (100 shares * $1.50 per share) and have the right to purchase 100 shares of AAPL for $110 per share before August 19, 2016. This would make your effective purchase price $111.50 (strike + premium).
At the time of this writing, AAPL is trading at $106. So why would we consider buying this option when our effective purchase price is $5.50 over the current price?!? The answer is leverage. While it would cost $10,600.00 to purchase 100 shares of AAPL ($5,300.00 with margin), you can control these same 100 shares with only $150. This, as with anything in life, comes with a price.
You must not only be correct about the direction of the stock but also the timing. In order for you to break even on the call contract, the stock price must rise $5.50 to $111.50 by expiration (52 days away in this case). Anything less and you will take a loss up to the cost of the option ($150).
What are the benefits to the buyer? The buyer is able to control 100 shares of AAPL with only $150 while purchasing 100 shares outright would have cost $10,600.00. Risk is limited to the cost of the option, or premium, which is $150. Stock ownership risk is $10,600.00 though few of us would let it get so bad.
What is the drawback to the buyer? Time is not on the buyers side. AAPL must reach a certain price, $111.50 in this case, before expiration just to break even. If 100 shares were purchased at $106, gains would be realized at any price above $106.
Example put contract: AAPL Oct 21 2016 $110 Put
Contract Details (actual values on 8/30/2016):
- Underlying stock: Apple (AAPL)
- Expiration date: October 21, 2016
- Strike Price: $110
- Premium: $5.40
This is the same expiration and the same strike price as the call example above, but this contract is a put. Purchasing this contract would give you the right to sell 100 shares of AAPL for $110 per share before October 21, 2016. For this right, you would have to pay a $540 premium (100 shares * $5.40 per share).
The same rules and logic that I discussed for the call apply here for the put, just in reverse. The put buyer is expecting AAPL to decrease, and AAPL must drop below $104.60 (strike – premium paid) by expiration for this trade to be profitable.
Up to this point I have only talked about buying options. Of course for every buyer there is a seller.
Selling, or writing, a call contract means you are obligated to deliver 100 shares of the underlying stock upon assignment. This means that if you own the 100 shares and the stock prices rises above the strike price your shares will be called away. If you do not own the shares, and you do not buy back the call contract, you will end up short 100 shares upon assignment.
Selling, or writing, a put contract means you are obligated to purchase 100 shares of the underlying stock upon assignment. If you are short 100 shares and the stock price drops below the strike price your short stock position will be covered at the strike price. If you are not short the stock, you will be the proud new owner of 100 shares at the strike price. Put selling is the basis of my strategy and is a great way to accumulate stock and earn some income.
The first thing you will notice in the examples above is that although the strikes and expirations are the same for the call and the put, the put is much more expensive to buy. The reason is that the put contract is in the money. The contract already has intrinsic value – meaning that if the contract were to expire today it would be worth $400 ((strike price – stock price) * 100 shares). The call contract is out of the money – if the contract were to expire today it would be worthless since the stock price is below the strike price.
So why is the call worth $150 if it has no intrinsic value? Time. This contract doesn’t expire for almost 2 months and the odds of AAPL reaching or surpassing the strike price by then are substantial. This is the very basics of option pricing: Premium = Intrinsic Value + Time Value, where Time Value = some very complicated math that involves things like time until expiration and volatility.
In the examples above, the call has $0 intrinsic value and $150 time value while the put has $400 intrinsic value and $140 time value. Any time value in an option premium will decay the closer it gets to expiration. So unlike the buyer, time is an option seller’s friend.
In reality, option pricing is much more complicated than this and requires many large books to fully understand it. For the purpose of understanding my strategy I only want to stress one of the factors, besides stock/strike price and expiration, that affects option prices: volatility.
High Volatility = High Option Prices
The reason for this is simple. High volatility means higher expected price fluctuations. Higher expected price fluctuations means increased likelihood of hitting a distant price target. Option sellers get paid more to take on the added risk of the underlying making a volatile move.
Time value decay and volatility are the two keys to my option income strategy and most strategies involving the sale of options.
Selling Puts To Accumulate Stock
Most of us don’t just go out and buy a stock at the market price on a whim. We do our research, determine a fair price for the stock and we wait for the stock to fall to an acceptable level. Then we buy.
Some of us add the stock to our watch list to monitor it and some of us will set a limit order for our desired purchase price. This is where the power of options becomes apparent. Think of your limit price as a strike price.
Instead of submitting a limit order for your stock you can sell a put with a strike price equal to your limit price. In this way, you are getting paid a premium to essentially set a limit order.
There are some differences of course. In order to acquire the stock the share price must be below the strike price at expiration. If it falls below the strike prior to expiration but then recovers you would not be assigned the stock (whereas you would have acquired the stock with a limit order). In this particular situation you would have made more money with a limit order. The other reason to use a limit order is if you don’t want blocks of 100 shares.
Let’s take a look at an example comparing a put sale vs a limit order for AAPL (actual values on 8/30/2016). AAPL is trading at $106.00. Two investors, Option Joe and Limit Bob, studied the charts, poured through the fundamentals and both have decided that $100 would be a great price to pick up some AAPL stock.
Limit Bob decides to set a limit order to buy 100 shares of AAPL at $100. Option Joe sells the following option contract: AAPL Oct 21 2016 100 Put. Option Joe receives a $220 premium for selling the put contract. Let’s take a look at the 3 possible outcomes:
- AAPL shares trade sideways or increase. Both scenarios leave our investors without any shares. Limit Bob gains nothing while Option Joe pockets the $220 premium. In this scenario the win goes to Option Joe.
- AAPL shares drop below $100 then increase to $105 at expiration. Limit Bob’s limit order would have been triggered, giving him 100 shares of AAPL at $100. These shares are now worth $105 each giving Limit Bob a $500 unrealized gain plus any dividends paid. Option Joe did not acquire any shares but still gets to pocket the $220 premium. Here the win goes to Limit Bob. However, Option Bob is looking for income and is content with the outcome.
- AAPL shares plummet. AAPL shares drop sharply and close at $95 at expiration. Both investors would buy 100 shares of AAPL at $100 in this case. Limit Bob picked them up on the way down while Option Joe was assigned the shares at expiration. The difference is that while Limit Bob has a $500 unrealized loss (($100-$95)*100), Option Joe only has a $280 unrealized loss ((($100-$95)*100)-$220). Option Joe actually purchased the shares at a discount due to the put premium received. Limit Bob might have picked up a dividend before Option Joe was assigned his shares, but this is nowhere near the premium Option Joe received. Another win for Option Joe.
For those wishing to just acquire stock, limits vs puts is a tough decision and one has to consider many different factors. For those of us looking for income and the opportunity to pick up shares at a discount the decision is simple: puts are the way to go.
My Option Income Strategy
My strategy is quite simple. I sell, or write, put and call option contracts to generate income. I sell the contracts when they are expensive (high volatility) and I buy them back when they are cheap (or they expire worthless).
There is, of course, another thing that can happen. Something that terrifies most people. Sometimes the stock moves against me and I get assigned on the contracts that I write (forced to buy 100 shares per contract at the strike price). Not to worry. I only run this strategy on stocks that I want to own.
In the relatively rare event of assignment, I simply collect dividends (if paid) and write calls against the new stock position until the shares are called away. This typically results in a break even on the shares, but can sometimes result in a profit depending on the strike of the calls that I write.
Step 1: Create a watch list
I create a watch list of stocks that I want to own and make sure they are optionable. I research the companies as I would for any normal stock purchase then I assign what I believe to be a fair value – a price where I would be comfortable owning the shares. This is typically a good 10-20% below the current price which is why the vast majority of my positions do not get assigned.
Then I go to the charts to find strong support levels and trend lines. These are the areas where I want my strike to be. If the stock happens to drop to my strike price I will be buying shares at support. In rare instances, if I am very bullish on a stock and there is support close to the current price, I’ll go ahead and sell a put at that level with the hope of being assigned. I get paid a very high premium for these positions making it worth the “risk.”
Step 2: Find stocks from list that are oversold and/or volatile
Then I regularly scan my watch list for stocks that are oversold (RSI and Stochastics indicators) and/or are very volatile. Volatility could stem from news, earnings, a general selloff of the market, etc. When markets fall or my stock of interest drops sharply option prices skyrocket. This is the time to sell. I make sure whatever caused the volatility spike doesn’t change my positive view of the company. If everything checks out I move on to the actual sale.
Step 3: Sell puts
Once I have identified a stock that I want to own, the price I want to own it at AND the option premiums for that stock are high I start looking for the specific contract(s) that I want to sell.
There are several parameters that allow me to quickly narrow down my options:
- I want to collect at least $100 premium to minimize commission damage
- My annualized return for the trade must exceed 20%
- Annualized return = ((net income / option requirements) * (365 / days to exp)) * 100, option requirements is the cash required to open a naked put (varies from broker to broker)
- The strike must be at or below my desired purchase price
- The expiration must not be more than 6 months away (I like quick turnarounds)
- I must be able to afford the purchase of 100 shares if I get assigned
After filtering out the contracts using these rules I am typically only left with a couple of choices. Do I go with a cheaper contract that is less likely to be assigned and just buy more contracts? Do I go for a longer expiration to squeeze out more premium? These are the types of questions I ask and the answers vary depending on factors like market conditions, my view of the stock’s likely direction and strength, how much I really want to own the stock (or am I more interested in the option income), etc.
Step 4: Evaluate / close position
After selling the put I immediately start looking for a reasonable exit. My target is to capture 75% of my premium in a relatively short amount of time. For example, say I sell a put for $100 and the value drops to $25 after a month. If there is still a substantial amount of time left until expiration (> 1 month) I will go ahead and close out. There is no point waiting months just to collect another $25. Instead, I take my funds and repeat the process.
If the opportunity to exit with 75% of my premium doesn’t present itself then I just wait for expiration. If the stock price is close to my strike I have a couple of options. I reevaluate the stock to make sure I still want it. If I don’t, I buy back the contract. If I really want the stock I do nothing. If I am on the fence I will set a limit order to buy back the contracts for $0.05. TradeKing graciously charges no commissions to buy back options for $0.05 or less.
Finally, if I was dead wrong and the stock drops well below my strike then I prepare for assignment. This involves making sure there is enough cash to cover the purchase, finding the next support level for stop-loss placement and formulating a plan for call sales.
Step 5: Repeat steps 2-4
When assigned shares the most important thing to remember is DON’T PANIC. This is all part of the plan. I refer back to steps 1/2 for comfort. I bought shares of a company that I want to own at the exact price I wanted! At a discount!
Now that I own a great company with great fundamentals at a bargain, I typically like to wait for a nice rebound before making another move. Then I plan my call sales. If the company pays dividends I check the ex-dividend dates. Ideally I want to sell my calls with an expiration just beyond the ex-date so I can capture a dividend.
Once the stock finds a bottom and begins to rebound I sell calls. If the rebound is strong and approaches my original put strike I might consider selling a call with a higher strike if I am still bullish. This would enable me to realize gains from the stock transaction in addition to pocketing the option premiums. If I don’t see too much upside I will sell a call with a strike equal to my original put, breaking even on the stock transaction but still collecting the dividends and premiums.
If the stock does not reach the call strike I have a few options. I can buy it back for a profit and repeat the process. I can let it expire and repeat the process. Or if my view of the company has turned sour I can simply close everything out. All along the way I am collecting premiums and dividends.
When I discuss this strategy with other investors I receive two common criticisms.
Wouldn’t you make more money if you just bought shares outright?
First of all remember that the purpose of this strategy is to earn extra income (primarily from option premium) and to acquire shares at a discount. I use my other portfolios for straight share purchases.
That said, the short answer to this question is yes. Assuming that you knew the stock would go up of course you would make more money just buying 100 shares. Unfortunately we don’t have a crystal ball.
Assuming that we can’t predict the future there are plenty of reasons to choose put sales over buying stock. Two of the biggest reasons are cost (it will cost much more to buy shares vs sell puts) and buying shares outright comes with more risk. Let’s go through an example using Netflix (NFLX, actual values on 8/30/2016).
The obvious advantage to outright stock purchase is unlimited upside. With the put sale the max profit is the premium received for the put which in this case is $158. That is where the advantages end.
Entering the put trade requires only $1700 (at TradeKing) whereas buying the stock will cost almost $5000 (using margin for both). In addition the put trade carries less risk. The potential loss is much less due to the lower purchase price and the premium received.
Finally, my favorite advantage with the put sale is the safety margin. In this example, NFLX would have to drop 14.4% to $83.42 to reach break even. Now that helps me sleep at night. At $83.42 the outright stock purchase would be down $1400…
And if NFLX does in fact drop to $83.42 or lower, I will consider myself lucky to own stock in a great company at such a low price.
What if the market tanks and you are assigned on ALL of your put positions?
This is something that will most likely happen to me at some point and it is admittedly a little scary. While this scenario is obviously not ideal there are two things that put my mind at ease.
First of all, most of the puts I sell would require a drop of 10% or more for me to be in danger of assignment. This is a HUGE drop and it doesn’t happen often. When it does happen, I am usually scrambling to buy as much stock as I possibly can anyways – so I’ll happily collect income from puts to acquire these discounted stocks.
The second thing is that I don’t take on more put positions than I can afford. While I’m technically writing naked puts, I always make sure I have the cash or assets to back it up.
The important thing to remember is to run this strategy on stocks you want to own. If you follow this rule there is no reason to worry about assignment.
Hopefully this post was helpful and provided you with some options basics. I apologize for the long post but believe me when I say that this is the short version. When I originally wrote this I basically had a book when I was done. I trimmed it down to what I though was most important. That said, if you want details on anything or have any questions don’t hesitate to comment below or shoot me an email at email@example.com. You can also check out all of my open and closed positions in my Option Income Portfolio for my trade details – updated daily.