Option Income – Low Risk Strategies

by Wes Bridel on May 4, 2011

in Stewardship

Option Income could be the key to vastly increased income and if done right, two methods are low risk strategies!  We’ve been discussing options, so if you’re not familiar with how they work, you’ll need to read the prior posts in the series starting here.  Now we’ll take a few posts to explain Put Option Income and then will move to Call Option Income.

Hopefully, we’ve drilled the idea into your head by now that most people lose money when trading options and trading options is extremely risky the way most people do it!  However, there are a couple easy strategies that can help you add income to your portfolio with no added risk with one catch.

The catch is that you have to want to buy a stock or ETF that has options traded on it at or near the current price.  For example, let’s say that you believe Intel (INTC) is an incredible company selling at a very fair valuation.  You would love to own INTC forever while watching them continue to expand their business and pay ever-increasing dividends.  What would you do about it?

Quote for INTC INTC – INTEL CORPORATION

Last      Change      Bid Size    Bid        Ask         Ask Size    High     Low      Volume            90-Day Avg. Vol.      EPS        P/E

21.47 -0.03         10             21.44    21.46        1               21.56    21.30   41,610,363    65,321,056                 1.86       11.55

(The above information is old and is here for educational purposes only)

Most people would simply buy the stock.  And there’s nothing wrong with that if that’s what you would like to do.  However, there are low risk strategies that might offer you better solution, such as Option Income…

Selling Put Options

Instead of buying the stock at current prices ($21.47), what if you agreed to let someone pay you money if you promised to buy Intel at a cheaper price at some date in the future?

Did we just say that someone will pay you to allow you to get a better price on the stock that you already want to buy??? Absolutely!

There are a couple catches.  The first catch was that you had to want to buy the stock.  The next catch is that you have to plan to buy the stock in even lots of 100 shares.  Since an option represents 100 shares, you have to commit to buying shares in lots of 100.  One hundred shares for every put option that you sell.

The final catch is that you have to be willing to only accept what you are paid upfront and take on the possibility that you won’t be able to buy the stock at near the price you wanted to.  You see, you are probably providing insurance to someone who owns these shares of Intel.  This person is scared that the market in general (or Intel in particular) will take a huge fall.  To protect himself, the person buys a put option from you which guarantees him the right to sell you his Intel shares at the price that you’ve both agreed upon which was less than the current price at the time you made the deal.  This offers him protection by limiting how much he can lose by holding the stock.

If INTC goes screaming higher between now and the expiration date, then you will have been paid up front for promising to buy the stock, but by the time the options expire, you will no longer be able to buy the shares at anywhere close to the value you had originally wanted to buy them.

Of course, you could take extra money and buy the shares if you believe this is going to happen, but then you are exposing yourself to the risk that the price changes direction.  In this case, you would now own twice as many shares as you had planned on buying.  A better way to do this would be to buy back your Put Option and buy the shares.  But this may or may not have been a profitable move because you wouldn’t have made as much money on the Put Options, and you would have paid a higher price to buy INTC outright.

It is probably best to simply be willing to let go of the chance to buy that stock (at least for now).  If you are willing to do this, the market will pay you for the simple promise to buy it, so take that profit and walk away.

This is Post 6 of a new series on stock options which we’ll be revisiting every few days.  You can find the first few parts at the following links: Pt 1, Pt 2, Pt 3, & Pt 4, & Pt 5.  You can check out the series we just finished on professional money management and funds by following these links: Pt 1, Pt 2, Pt 3, Pt 4, Pt 5, & Pt 6.

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