Work-Free Wealth

Income Investing for Financial Independence and Early Retirement

Incremental Income with Options

Volatility has returned to the stock market after a long time of unusual calm.  While this may seem scary, it is actually good news if you want to get some incremental income from options.  The risk premiums that you can get as an option seller rise with increasing volatility.  I am not talking about any exotic option strategy either.  You can get incremental income on stocks you already own by selling covered calls. Additionally, if you want to buy a stock at a certain price, you can sell a put option.  You will get the stock if is below the strike price of the option at expiration date.  In either case, you get to keep the option premium.

The key to this strategy is to pick a stock that you want to own anyway.  Ideally, it should trade in a certain trading range.  If it approaches the bottom of the range, you sell put option. When it gets closer to the top of the range, you sell covered call options (assuming you own the stock).   It is a nice income enhancing strategy for large cap stocks.  It is not suitable for super volatile stocks that move out of their trading range on either the way up or down.   Let’s walk through the scenarios for selling call and put options.

Call Options

Per Investopedia “A call option is an agreement that gives an investor the right, but not the obligation, to buy a stock, bond, commodity or other instrument at a specified price within a specific time period.”

The specified price is the “strike price” and the “specified time period” is defined by the expiration date.  An option that does not expire for 3 months will be more expensive than an option that will expire next week.  This option premium goes to the seller to the option.  The good thing for the option seller is that the option premiums erode with time.

Let’s assume you own 300 shares of AT&T and you don’t mind selling your shares when the price hits a certain threshold.  You could sell 3 call contracts for your AT&T shares.  Each option contract is for 100 shares.  If the option premium is $1.5 for the given expiration date, you will receive $450 minus commissions for selling the contracts ($1.5 * 300).   If AT&T trades above the strike price at the expiration date, your shares will be automatically sold (“called”) for the same as the strike price.  For a $40 strike price, you would receive 300*$40. Of course, you get to keep the option premium that you already collected as well.

You lose any upside potential beyond the strike price when selling calls. That is why this is not what you want to use for the potential next Amazon.

Here is how the profit and loss picture looks like if you sell a call:

Your profit is capped at the option premium plus the difference between strike price and current price.  If the stock drops in value, you still own it and lose accordingly but you can console yourself that your loss was buffered by the option premium you get to keep.

Put Options

Let’s say your AT&T stock was “called” at a nice price but it has since fallen again to a price you would consider buying it.  Instead of setting a limit price and buying it outright, you can sell a put option.

Per Investopedia “A put option is an option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time. This is the opposite of a call option, which gives the holder the right to buy shares.”

That means if you sold 3 put option contracts for AT&T for a $1.50 premium, you collect $450 minus commissions upfront.  If AT&T is below the strike price on the expiration date, your brokerage will get the stock at the strike price.  This is why you should have enough cash in your account to buy the 300 shares at the given strike price.  That is called a cash-covered put.

Of course, if the stock is much cheaper than the strike price on the expiration date, you will be annoyed that you did not get it cheaper.  It is still better than having bought it directly with a limit order since you got the option premium upfront.  Alternatively, if the price is higher, you are not getting to buy the stock but you get to keep the option premium and can sell another put.

 

So, if volatility has you down, think about this is a potential way to make money.  Alternatively, you can just ignore and invest as usual.

2 thoughts on “Incremental Income with Options

  1. A good post, I do want to learn more about the more complicated financial products out there….but then I wonder if I knew more, would I be tempted to invest more actively?

    • I think starting slowly is always a good idea until you are comfortable and get a good understanding of the level of risk appropriate for your comfort and portfolio.

Leave comment

Your email address will not be published. Required fields are marked with *.