How to Generate Income with Options
In a low-income, zero-interest rate world incorporating an option writing strategy may give your account a boost. Writing options on stocks you own or want to own is an excellent way to increase your income without altering your asset allocation strategy or investment plan. If you own individual stocks, this could be a strategy for you.
There are several ways to generate income from trading options, but I will only focus on two popular strategies – covered call and put writing.
Covered Call Writing
A covered call or buy-write allows you to generate income on stocks you own if you're willing to sell your shares at a specified price. For example, let's say you own 1,000 shares of Apple (AAPL), currently trading for $123.25 per share, and you would like to sell them at $130. As a result, you sell the January $130 call for $2.00. Because you own 1,000 shares, you sell ten contracts (one contract = one hundred shares of stock). The $2.00 is the option premium you'll receive, so ten contracts will generate $2,000 income (10 × 2.00 × 100) before fees. The $2,000 will credit your account on the day of your trade.
If Apple stays below $130 on the third Friday in January (expiration), you'll keep your shares. You can then sell another call option on Apple, expiring in February, March, or April, and repeat the process. If it trades above $130 at expiration, you're obligated to sell your shares at $130, regardless of how high it trades above the strike price. If Apple closes at $200 on expiration, you're still obligated to sell the stock at $130 and forgo the $70 profit.
As a warning, never sell a call option without owning the underlying stock position because your risk is unlimited.
Put writing involves selling a put option on a stock you want to own, comparable to placing a limit order on a stock you wish to purchase at a lower price - except you get paid to wait. For example, if you want to buy Apple at $110, currently selling for $123.25, you can enter a limit order and wait for it to trade to your price, or you can sell a put and get paid.
When you sell a put, you're obligated to purchase the stock if it trades at or below the strike price at expiration. If you sell an Apple January $110 put, you'll receive a credit of $1.13 per contract. If you sell ten contracts, the credit will be $1,130 (10 × $1.13 × 100), before fees. If Apple trades at or below $110 per share, you're obligated to purchase 1,000 shares at $110 regardless of how far it trades below the strike price. If Apple stays above $110, your option will expire worthless, and you'll profit on your trade, and then you can sell another put option expiring in February, March, or April.
A put-writing strategy is best suited for investors with a high tolerance for risk. It's also recommended you only sell puts based on the amount of cash in your account. This strategy is known as a cash-covered put. For example, if your cash balance is $25,000, you can sell ten put contracts on a $25 stock (10 contracts = 1,000 shares; 1,000 shares x $25 = $25,000).
I trade options to generate a few extra dollars each month; it's my side hustle. I mostly sell puts on stocks that fall sharply, which increases volatility and boosts the amount of premium I receive. When stocks fall, fear rises. An ideal trade for me is to sell a put option on a stock that is dropping 20% or more with a delta of less than 20 (If an option has a delta of 20, it means there's a 20% chance the stock price will touch my strike price). My time frame for selling a put on a stock that's getting crushed is three to four weeks because an option is a wasting asset, so if the stock recovers, the option will expire worthless, which is my goal.
A stock rarely drops 20% or more two or three days in a row, in my experience. If a company misses its earnings or revenue targets, investors sell the stock and drive it down to unrealistic levels. When this happens, I try to sell my put option when the market opens and fear is spiking. When investors realize the company is not going out of business, the selling will stop, and my option trade becomes profitable.
Of course, not every option trade is profitable, so I'm quick to cut my losses if I'm wrong. I want to live to see another day.
Options involve risk, but they're an excellent way to generate a few extra nickels.
Contract: One option contract = 100 shares of stock.
Expiration: The day the option contract expires. Options expire on the third Friday of every month. Several stocks also have options expiring weekly.
Call Option - Buyer: An option giving the buyer the right to purchase a stock at a specified price.
Put Option - Buyer: An option giving the buyer the right to sell a stock at a specified price.
Call Option - Seller: An obligation to sell stock at a specified price.
Put Option - Seller: An obligation to buy a stock at a specified price.
Premium: The amount you must pay to purchase an option or the amount you will receive when you sell an option.
Strike Price: The exercise price where you can buy a call or sell a put.
At-the-money: The stock price is equal to the strike price of the call or the put.
Out-of-the-money: A call option where the strike price is above the stock price. A put option where the strike price is below the stock price.
In-the-money: A call option where the strike price of the call is below the stock price. A put option where the strike price is above the stock price.
Delta: The amount by which an option premium moves divided by the dollar-for-dollar movement in the underlying asset.
Volatility: The measure of the fluctuation in the price movement in a security over a period of time.
December 14, 2020
Bill Parrott, CFP®, is the President and CEO of Parrott Wealth Management in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process so our clients can pursue a life of purpose. Our firm does not have an asset or fee minimum, and we work with anybody who needs financial help regardless of age, income, or asset level. PWM's custodian is TD Ameritrade, and our annual fee starts at .5% of your assets and drops depending on the level of your assets.
Note: Investments are not guaranteed and do involve risk. Your returns may differ from those posted in this blog. PWM is not a tax advisor, nor do we give tax advice. Please consult your tax advisor for items that are specific to your situation. Options involve risk and aren't suitable for every investor.
 The Bible of Option Strategies – The Definitive Guide for Practical Trading Strategies by Guy Cohen