Do you want more income? Writing options is an excellent way to generate a few extra dollars if you own individual stocks. Rising interest rates and increased volatility have made option premiums ripe for picking.
Incorporating an option writing strategy can boost your cash flow in a low-interest rate world. Writing options on stocks you own or want to own is an opportunity to increase your income without altering your asset allocation or investment strategy.
There are numerous ways to generate income from trading options, but I only focus on two popular strategies – covered call and put writing.
Covered Call Writing
Covered calls allow you to generate income on stocks you own if you’re willing to sell the shares at a specified price. For example, if you own 1,000 shares of Apple (AAPL), currently trading for $166 per share, and you want to sell them at $180, you could sell the June $180 call for $2.94. You can sell ten contracts since you own 1,000 shares (one contract = one hundred shares). The $2.94 is the option premium, so ten contracts generate $2,940 in income (10 × 2.94 × 100) before fees. The $2,940 will credit to your account on the day of your trade.
If Apple stays below $180 at expiration, you’ll retain your shares. You can then sell another call option on Apple, expiring in July, August, or September. If it trades above $180, you’re obligated to sell your shares at $180, regardless of how high it trades above the strike price. If Apple closes at $200 at expiration, you’re still obligated to sell your shares at $180 and forgo the $20 profit.
Warning: Never sell a call option without owning the underlying stock position because your risk is unlimited.
Put writing involves selling an option on a stock you want to own, comparable to placing a limit order to buy shares at a lower price – except you get paid to wait. For example, if you want to buy Apple at $150, currently selling for $166, you can enter a limit order and wait for it to trade to your price or sell a put option and get paid.
When you sell a put option, you’re obligated to purchase the stock if it trades at or below the strike price at expiration. If you sell an Apple June $150 put, you’ll receive $2.98 per contract. If you sell ten contracts, the credit will be $2,980 (10 × 2.98 × 100). If Apple trades at or below $150 per share, you’re obligated to purchase 1,000 shares at $150 regardless of how far it trades below the strike price. If Apple stays above $150, your option will expire worthless, and you’ll profit on your trade. Then you can sell another put option expiring in July, August, or September.
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 primarily sell puts on stocks that fall sharply to boost the premium I receive. When stocks fall, fear rises, and so do volatility and option premiums. 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 puts is three to four weeks because an option is a wasting asset, so if the stock recovers, my 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 stops, 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 because I want to live to see another day.
Options involve risk, but they’re an excellent way to generate a few extra nickels.
Volatility is not risk. And historic volatility does not necessarily project future volatility. ~ Seth Klarman
April 14, 2022
Bill Parrott, CFP®, is the President and CEO of Parrott Wealth Management, located 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.