This post is going to talk about perhaps my favorite source of investment income. It’s something that very few people take advantage of because it can be a little confusing to learn but is ultimately well worth the time. I will go as far as to say that it is probably the most misunderstood and underutilized investment security available to retail investors. What I’m referring to are option contracts; specifically selling options to generate additional portfolio income.
Options are something that most people have heard of but few understand so rightfully so they simply avoid them. I’ll try to simplify the basic concept of selling options in this post so you can get an idea of the value it can provide to a portfolio. If you’d like more detail on the various ways you can incorporate options into your investment plan, check out this video series on my website.
The biggest concern I hear when talking about options is something like “Aren’t options really risky?” In short – no, they’re not. When used properly they actually reduce risk in a portfolio. Like any investment strategy, you can incorporate options in a very aggressive manner which can be “risky,” or take a far more conservative approach that’s appropriate for retirement investments.
Here’s a little overview: An option is a security known as a derivative because it derives its value from an underlying security, like a stock. Just like being able to buy and sell stocks on the open market, as an investor you can buy and sell options on the open market. You’re free to choose any option contract that you like. What we’ll be focusing on in this post though is just selling options.
Sometimes I’m asked how you can sell an option you don’t own in your account. This is because most people think about investing as a buy-first process and hopefully sell later for a profit. However, you can actually reverse the process where you sell a security for money at a price you think is “high” and then hope to buy it back, to close the position, at a lower price for a profit. Doing this with stocks can be a pretty risky strategy and usually isn’t recommended for most investors. However, selling options can be far more appropriate and often a very smart thing to do.
There are two types of options: call options and put options. By selling a call option against a stock, you are granting the person that buys the call option from you the ability to buy the underlying stock from you (they can force you to sell the stock). By selling a put option against a stock, you are granting the person that buys the option from you the ability to sell the underlying stock to you (forces you to buy the stock). In order to keep this conservative and appropriate for your retirement portfolio, you want to make sure you either hold the underlying stock when selling a call option (in case you’re forced to sell it, you have the shares available) or have enough cash to buy the underlying stock when selling a put option (in case you’re forced to buy the stock, you have the money available). This is called “being covered.”
If that was tough to follow, let’s break this down with examples of each.
Selling Call Options
Nearly all investors own stocks in their portfolio. If not individual stocks, then exposure to stocks through either mutual funds or ETF’s. As a side note, you can sell options against most ETF’s but not against mutual funds which is one big benefit ETF’s have over mutual funds. With interest rates as low as they have been the past few years, many investors have owned dividend paying stocks as a source of income in place of bonds. These stocks are great long-term income investments for many reasons. However, the other side of the coin is that they can also add a lot of volatility to your portfolio which goes against the point of owning bonds in the first place – income AND stability (for diversification) during those times that stocks take a dive.
This is where selling call options comes into play. By selling call options against the dividend paying stocks an investor owns for income, they are able to reduce the downside risk. Here’s how it works:
Let’s say you own 100 shares of a stock that pays a 4% annual dividend trading at $50 per share – that’s a $5,000 investment that pays $200 per year in dividends. You can use your 100 shares as collateral to sell a call option (I chose 100 because you need 100 shares per option contract). Since we have the ability to select any option we like, we’ll sell a call option with a strike price, the price at which you could be forced to sell the stock, above the current market price of $50. For our example, let’s say we choose to sell a call option that expires in 3 months with a strike price of $55, and for selling this option we’re able to collect another $1 per share in premium income. Since we’re selling this call option to some other investor in the market, they are going to pay us cash (called the premium) for it.
We now own 100 shares of stock worth $5,000 and we have an extra $100 of cash deposited into our account ($1 per share of premium x 100 shares) that we collected by selling the call option. However, keep in mind that we could be forced to sell our stock at the strike price of $55 so our upside potential is limited until the call option expires in 3 months. But that’s OK! Remember, we own this stock for the dividend income; any appreciation in the price of the stock is a bonus. Our concern is the potential downside risk that the stock might fall.
Over the next 3 months, we’ll collect one quarterly dividend of $0.50 per share plus the additional $1 per share from selling the option. This $1.50 total collected represents 3% income in three months.
Now let’s fast forward 3 months and look at some different scenarios on the day the call option expires:
- If our stock is trading below the strike price of $55 per share, the call option will expire, we keep our 100 shares and our upside is no longer capped. It will expire because the person that had initially bought the option from us will not elect to buy our 100 shares of stock from us at a price of $55 when he is able to purchase the stock in the open market for less than $55/share. We’re now free to repeat the process again next quarter and choose a new call option to sell for additional income!
- If our stock is trading above $55 per share, the option will be exercised, meaning we’ll be forced to sell our 100 shares of stock for $55/share. Even if the stock jumped to 70, we’re still forced to sell at 55. That’s the risk of selling a call option against your stock but I’d hardly call it a risk because we just collected $1.50 of income plus $5 of appreciation for a total gain of $6.50/share – that’s approximately a 13% return1 in 3 months on an investment we owned in place of bonds! This outcome is a lot less common because dividend paying stocks tend to be relatively stable and don’t often make big jumps that quickly, but it does happen from time to time.
- The last scenario is when our stock has fallen and is now trading lower than $50/share. We’re down on the principal of the investment, however, we’re better off by selling the call option (over not selling options) because we collected an additional $1/share of income which helped to cushion the downside. Volatility is simply part of investing in stocks but we’re focusing on the income generated which in this case was approximately 3% (dividend plus call option premium). We still own the stock and it will generate additional income next quarter (and hopefully bounce back to $50 or higher).
As you can see, selling call options against stocks you own for the dividend income is a win-win strategy. You’re either forced to sell your stock but earn a nice return, or you keep the stock and boost your income while reducing your downside risk.
Selling Put Options
Selling put options is almost the opposite of selling call options. As a reminder, by selling a put option you could be forced to buy a stock at the strike price. The key to making this safe is to 1) make sure you’re “covered,” meaning you have enough cash in your account to purchase 100 shares of the stock at the strike price for each option you’re selling, and 2) you only sell put options against stocks that you want to own and would be happy to buy if they drop.
So here’s how it works: let’s say we have some cash that we’re looking to invest. We identify a quality dividend paying stock that we want to own for the income but we’re not enamored with the price right now. However, if it drops a little, we would be willing to step in and buy 100 shares. It’s trading around $50 per share and we would be willing to buy it if dropped a few points to say $45/share. We don’t know if the stock will drop to $45 but we also don’t like earning 0% on our cash while we wait… so what we can do is sell a put option against the stock with a strike price of 45. In our example, this put option expires in 3 months and the premium (cash) we collect is $1/share ($100).
Fast forward 3 months and we’ll see what happened:
- On the day the put option expires, if the stock is trading below $45/share, we will be forced to purchase 100 shares of the stock at $45, an investment of $4,500, even if it’s trading much lower. However, that was the game plan in the first place. We identified $45 as our target price and said that was a good opportunity to buy. Plus, it sure beats if we would have bought the stock up at $50! Our total purchase cost is actually $44/share since we bought at $45 but collected $1 of premium at the outset.
- On the day the put option expires, if the stock is trading above $45/share, the put option will expire and we get to keep the $100 of premium free and clear. We just earned a little over 2.2% on our cash ($100/$4,500, less any transaction costs) in 3 months and now we can scan the market for a new and/or better opportunity.
Just like selling call options, selling put options is a win-win strategy. We’re either earning a nice return on our cash while we wait for an attractive opportunity to roll around, or we’re buying stock in a company that we like at a discount to where it was trading a few weeks earlier (buying on a dip). Since we’re only buying after a stock drops below the strike price, this enforces a bit of discipline into our investing and prevents us from chasing stocks that are “high” in price. This creates a margin of safety that significantly reduces the downside risk of investing in stocks, which improves long-term performance.
Options are certainly a complicated investment security and while this intro only scratches the surface, I hope you can see the big picture in terms of the value they offer a portfolio when incorporated the right way. Selling covered options will increase the yield and reduce the volatility of your stock positions – two huge benefits to income investing. Lastly, anyone can be approved for selling “covered” options in their account because it’s such a relatively low risk strategy, but it’s always a good idea to do your research or work with a qualified professional before putting real money on the line.
Attention clients – you may want to re-read this post; you’re soon going to see more of this coming your way.
Thanks for following!
-Nick
Click here to see the last post in this series.
Options involve risks and may not be suitable for all investors. Please read the Characteristics & Risks of Standardized Options Handbook before investing in options. The content of this post is provided as general and educational information only and is not intended to provide investment or other advice. This material discusses certain investment strategies that we utilize for those clients that we deem appropriate and is not to be construed as a recommendation or solicitation to buy or sell any security, financial product, or instrument, or to participate in any particular trading strategy. RCN Wealth Advisors provides investment advice solely to its clients that have hired RCN Wealth Advisors for financial planning or through the management of their investment accounts.
1 Return calculated as: 6.50/50, less transaction costs