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.