Option selling as an income strategy

I’ve covered one of my alternative investment strategies for retirement portfolios already, in my post on structured products. Today, I’ll introduce the primary strategy I use to generate income from my cash balance – option selling. Cash is an important part of any asset allocation. It allows an investor to take advantage of opportunities in stocks when markets pullback and it protects the rest of your portfolio if unforeseen spending requirements arise. The problem with cash, particularly in today’s environment, is the negative real interest rates you earn on any cash investments. Fortunately, you don’t have to put up with poor returns on cash. Option selling is a mildly aggressive income strategy which done right can generate 10-20% annual returns with not much risk!

This may sound like heresy to some. After all aren’t options, like most financial derivatives, extremely dangerous and risky, ‘weapons of financial mass destruction’ as Warren Buffett has said? Leaving aside the Buffet double speak for now (he does invest heavily in options by the way), the answer to this question is yes, maybe, depends on how you use them. My more uncouth answer is phooey! This is what the elites want you to believe. Options can be very conservative investments. For a well educated investor who follows a strategy option selling is a great way to generate extra income. Lets get to the strategy.

Note: I’m not going into the basics of options. If you want to learn more about options, this is a good place to start.

First of all, option selling takes advantage of a key aspect of options. The majority of options expire worthless. Why? Because to make money when you buy an option the investor has to be right on two counts – the direction of the stock price and the timing of that move. Its hard enough to predict the former but to be right on both price and timing does not put the odds in ones favor. So, a strategy of selling options automatically puts the odds in the favor of the investor.

Second, this strategy involves always using covered options, no naked options. An investor always sells either covered calls, where you own the stock, or cash-secured puts, where the cash is ready at hand to buy the stock. Naked options are just too risky.

Third, the basic mechanics of the strategy are as follows:

  • You begin with a cash balance
  • You sell cash secured puts on a given stock and receive the option premium
  • Your maximum profit on the position is the option premium, i.e. you want the option to expire worthless
  • Your income is the option premium divided by the stock price
  • Before entering the position, you establish your exit point, when you will buy back the option if the trade goes against you. You will not be right 100% of the time so you must have a risk management strategy.
  • If you choose to have the stock put to you by option expiration, you turn around and sell a covered call on the stock and generate more income.
  • Repeat as necessary

Lets see an example of this strategy in action.

  • On Oct 1, 2010 with Intel trading at $19.32, I sold the Intel Nov 2010 $19 puts and received a premium of $0.75 for each $19 put option.
  • My yield on my investment was, $0.75/$19, or 4%. The options expire on Nov 20, 2010. This is approximately a 2 month investment . That’s a 4% return for 2 months which is 24% annualized return on my cash if the option expires worthless.
  • The exit point I established was Intel at $18.25, the $19 strike price of the option minus the option premium. If Intel would have hit $18.25 I would have exited the position by buying back the put option. The loss on the trade would depend on when you bought back the options, best case you would have broken even on the trade. Worst case you would buy back the options at approximately double the option price, $1.50, if Intel went to $18.25 the day of your trade.
  • On the other hand you can rife the trade to expiration. The risk taken here is if Intel was trading below $19 and above $18.25 on Nov 20th you would have to buy Intel shares at $19, the stock would be put to you.
  • If the stock was put to you you could have sold calls on the new stock position, probably Dec 2010 $19 calls for more income.

That’s it. I chose this example because the options have not expired yet so you can see what happened to the position. Intel has not traded below $19 since Oct 1 and in fact has moved up nicely to over $21 a share. So, it looks like the option will expire worthless this Friday. In fact, the option has lost so much of its value a couple of weeks ago that I closed my position by buying back the put at $0.03, after making 90%+ of my max profit, and rolled it into a higher yielding position.

For me the most important aspect of this strategy is finding the right stock, a stock that you know well and are very happy to own at a given price. Every investor needs to identify the type of stocks they would not mind owning at a given price in order to execute this strategy. I have found that if you try and implement this strategy on stocks you don’t know and just happen to have high option premiums you will not be successful. But that could be just me. For me, the right stocks for this strategy are dividend paying stocks with dividend yields of 2.5% or above, and with option premiums of 2.5% for 3 months, or 10% annualized.

That about covers the major points of this income generating option selling strategy. There are obviously details that I left out. If you’re interested in learning more, comment on this post, and I can generate more posts on this approach. I think this strategy provides great returns for the associated risk. And the risk can be well managed with a methodical approach. I much prefer this strategy to leaving my cash sit in savings or buying bonds in today’s yield environment. Those approaches are riskier than selling options for me.

Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.

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14 Responses to Option selling as an income strategy

  1. wyattearp says:

    dear, sir

    I stumbled across your blog today, and enjoyed it. You are correct with the SHORT OPTION STRATEGY! I have had decent returns selling OTM index options which trade weekly! these options are CASH SETTLED, EUROPEAN STYLED(only excercized on expiration day, so not subject to early exersize if your short CALLS or puts go ITM). Your OTM shorts(CALLs or PUTS) are covered with further OTM LONGS(bought options) which specifically reduces your margin risk to the difference between them. Trade duration is only 7-8 days, so all you have to do is figure whre the SP500(SPX) or the NASDAQ(NDX) will be in a weeks timeframe and strategically place your short/long PUT &CALL legs! If the trade goes against you all you have to do is BTC your short PUT or CALL side as they both cant go ITM. Known as the IRON CONDOR trade this option strategy takes advantage of TIME DECAY (THETA). You may want to paper trade this strategy as its the best I have found!

    • libertatemamo says:

      Thanks for the comment. I’ve done some research into iron condors but nothing active yet. Mark Wolfinger at Options for Rookies is a big fan of iron condors as well.


  2. charles says:

    Just wanted to say I agree with and enjoyed your article. I really like to see ppl who understand that a simple approach to premium selling is much safer than hoping to achieve alpha in an equity.Unfortunately the public is largely aware of “buy and hold” or maybe shorting a stock but not much else. covered calls and cash puts are my favorite and closing out my positions when in doubt has always been damage control for me. Keep up the good work!

    • libertatemamo says:

      Thanks Charles. I agree that the risk is highly manageable wrt to option selling. It takes some learning but well worth it.


      • Simon says:

        I hate to be the bearer of bad new but it’s not that simple. Weeklies are dangerous as your playing with short gamma which can kill your position is you get it wrong and iron condors can easily lose if you get the volatility wrong.

        What concerns me the most is the short put strategy. You can’t just simply buy back the short puts at your break even as they would’ve increased in vlaue considerably making it a much bigger loss.

        • libertatemamo says:

          Simon, thanks for the comment. I said nothing about weeklies or iron condors in my post. You are right that weeklies bring other risks into the picture.
          You can lose in options for all kinds of reasons.

          On the short puts, at or very near expiration when there is no time premium left, you would be able to buy the puts back for intrinsic value. But you are correct if the stock tanks right after you enter the position then you would have to buy back the puts at a loss. Which is fine, the point is to determine a loss point before you enter the trade.


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  5. Tom says:

    Hello, I really enjoy your portfolio management model and have implemented the same over the past month and a half (timing was pretty tough for the dividend investment portion, but the stocks I have chosen are there for the long term and have already regained half their worst losses.

    The option sale strategy has also gone well with my first three contracts expiring at the end of the coming week. Two are well out of the money and in all likelihood will expire worthless. One is under water, but I believe it to be a function of the market volatility and some temporary next quarter earnings hit, so I am happy to own it with an effective dividend return north of 6%.

    Now as I look to re-sell the freed cash from the OTM contracts I am challenged by too much good selection (Vix as you know is very high).

    My question to you, if I may, is with Vix as high as it is, and stocks as beaten down as they are, should I look at well ITM 3 month contracts versus shorter closer to the money. I am drawn toward locking in the premiums of the ITM contracts with again the concept that I would be pleased to own the stock if put to me, but your advice has been to keep it short and close to the money with a strike at the bottom of the trading range.

    • libertatemamo says:

      Hi Tom. I never sell ITM put options, I always use out of the money contracts. Its part of my risk management strategy. I’m always asking myself, ‘what if I’m wrong. what is the price I think is undervalued is not but is truly much lower…?’. The OTM contracts give me more margin for error. Also shorter term contracts reduce risk. You only need to be right for so long. The longer the contract the more time your thesis needs to be right. Also, the annualized premium on shorter contracts are always higher than the longer contracts. So, I like to keep it short and use OTM puts primarily for risk management. The biggest risk with selling options is the risk of the big blowup, i.e say 9 out of 10 trades go well but the 10th trade costs you 50% cash secured put value. Usually, about once or twice a year I’m really wrong on the value of a stock in a trade I’m using. If it wasn’t for my for risk management such a loss could blow my entire profits for the year. Something to remember is, you will be wrong, sometimes big time, the key is how you handle being so wrong. Hope that helps.


      • Mike says:

        I agree with the OTM strategy, but to help with rick, the safe solid stocks are the key. What really could go wrong with IBM, or Intel, in a months time? I know anything is possible but much safer.

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  7. kevin daly says:

    I subscribed to your Blog in the last few months. Recently retired I’m interested in what you have to say. Can you tell me the brokerage firm you use for your option strategy? And what their commissions are if the option is Put to you?

    Thank you for your time

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