How do you Generate Income Selling Put & Call Options

by Wes Bridel on June 6, 2011

in Stewardship

Selling Put & Call Options: A Full Cycle

We’ve now shown you how to sell put and call options for income. How do these two option strategies fit together?  Very nicely.  You can sell Put Options until you are put the stock and then sell covered call options until your stock is called away.  If the market environment still seems to set up well for this strategy you can then repeat.  Let’s run through an example…

You like Intel and would be happy to buy it at the current price of $21.47.  However, now that you fully understand options, you want to use them to increase your income and reduce your risk on Intel.

So instead of buying 100 shares of Intel, you sell One Put Option at a strike price of $20 with an expiration date of February 19th.

Imagine that when February 19th arrives, the price has not moved much and is still selling around $21.50.  As a matter of fact, the stock market doesn’t really do much of anything over the course of the full first year that you are selling Put Options for Intel stock.  It occasionally dips below $20, but never ends up there when your option expires.  You repeat the sale of 2 month options for a full 6 cycles and collect $228 in option premium.  At the end of the 6th cycle (one year into our example trading range), the market drops and you end up being put the stock at $20.  You invest your $2000 on the 100 shares of Intel and now own Intel at a price above the current market price of $19.83.

Now that you own the Intel shares, you go from being a seller of Put Options to being a Seller of Covered Call Options.  You sell one call option contract for a two month out contract and receive about 1.12%.  At the end of the contract expiration you decide to repeat the sale and continue to do this for a full year.  At the end of that 6th contract (the end of year two in our example), the price of Intel moves above your strike price and your shares are called away from you (you must sell them to the buyer of your option).

You have received 6.7% in option premium income on top of the 2.9% that you would receive in dividends from Intel.

In total you made $228 in the first year you of selling Puts and $192 in the second year of selling Covered Calls and collecting the dividend for a total of $420 on your investment of $2000 which is 21% over two year.  If the price of Intel at the end of two years is still hovering around $22, you will be extremely happy because you would have earned 21% gross on Intel while a simple “buy and hold” investor would have only earned 2.4% (end price of $22 divided by original price of $21.47)

You can see how powerful using options can be to provide yourself with income even in an environment of zero interest rates when most people are struggling to find a couple percent.

However, there are possible negative outcomes to this scenario.  If the price of Intel falls to $3, then it will take you many, many, many years of selling call options to recoup your losses.  Of course, we said this was only a no risk strategy if you already knew you wanted to own the stock.

The other risk is that the price of Intel could move to $100 while you are under contract.  You would helplessly watch as the price zoomed out of sight knowing that the person you sold your option to is going to earn almost all of the appreciation.  You will only get the 21% total return that we calculated (or whatever your individual trade returns.)  You give up this upside potential in order to receive the guaranteed income.  To use baseball jargon, if you’re willing to give up home runs, you can hit singles and doubles all day long.  As most baseball fans know, the team that can consistently get on base is almost always going to beat the team that is trying to hit home runs, but ends up usually striking out.

It’s the same with investing, if you can consistently make nice gains, you will outperform most people that are trying to use one trade to make themselves rich.

Last Words on Options

We’ve stated this a few times, but will do so one last time here.  It is better to sell options when volatility is high rather than when it is low.  This is for a couple reasons…

1)      If you’re selling Put Options, there is a higher chance of being put the stock if volatility is extremely low because this usually precedes a market correction.  The drop in stock prices will lead you to being put the stock without having collected that much option premium.

2)      Because volatility is low, the income that you earn for taking on the risk will be lower.  It’s better for you to earn higher income with lower risk by selling options to the market when everyone else is scared.  (Like when you feel the market has finished falling.)

This is Post 11 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, Pt 6, Pt 7, Pt 8, Pt 9, & Pt 10.

SocialTwist Tell-a-Friend

{ 0 comments… add one now }

Leave a Comment

You can use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>

Previous post: The Federal Reserve’s Problem

Next post: The Fed’s Big Decision