The following is a guest post by Chris Douthit of OptionStrategiesInsider.com.
By selling options, traders can put the time advantage on their side.
Most other investment types require the trader to be correct about the direction of the asset. For example, buying stocks. If the stock goes up, you win, if it goes down, you lose.
Buying options is another go-to strategy used by most options traders, but here you have time working against you. Every day the stock does not move in your favor, you lose money.
But by selling options, traders can simultaneously collect cash and reduce risk. Because time keeps moving along, the options sold will continue to decay and generate cash within portfolio.
By selling puts, traders are able to collect cash, referred to as the premium, in exchange for agreeing to buy the stock at a later date for a predetermined price.
Smart option traders generate income by selling out of the money puts in stocks they wish to own. For example, if stock XYZ is trading $50 and you wish to purchase the stock, but only want to pay $45, you could sell a 45-strike price put going 30-days out and receive a $2 premium.
This means you would receive $200 for every contract you sold. You would receive this money for doing something you want to do anyway… Obligating yourself to buy a stock you want to own.
Once you open the trade, there are two possible outcomes. First, the stock does trade below $45, and you are forced to buy it at that price. But because you received a $2 premium when you open the trade, your net cost basis is $43. That’s 14% less than what you would’ve paid had you bought XYZ at $50 when you initially considered the trade.
The second possible outcome is that XYZ continues to trade higher. Although that does mean you don’t own the stock, you will get paid $200 to watch trade higher. Because you sold a 45-strike price put going 30-days out, your investment bank would hold $4500 to secure that $200 profit. That may not sound like a lot of profit on the surface, but that works out to be a 4.4% return over 30 days or a 53% return annualized.
Imagine if you could make a 53% annualized return on all your investments!
I never like watching a stock I want to buy trade higher, but I’m more than happy to if I’m getting paid cash to do so.
This is why selling puts can be such a powerful tool, either you make a fantastic return or you buy a stock you want to own at a discount. In both cases the traders gets a fantastic benefit.
I would never recommend anyone sell calls naked unless they have an ample amount of experience. However, that doesn’t mean you can’t sell calls against stock already own, commonly referred to as a covered call.
This means you could buy XYZ for $50 and then sell a 55-strike price call option contract going one month out for $2. That $2 premium is yours to keep no matter what happens, but you are obligating yourself to sell the stock at $55 if XYZ trades above this level.
For example, if XYZ traded up to $60, you would be forced to sell the stock at $55, but because you received a $2.00 premium when you opened the trade, you would have $7.00 of profit resulting in a 14% return over 30 days, that works out to be 168% annualized.
It’s true that in this example, you would’ve made even more money had you not sold the call, but you have to give up something in order to get something. In this case, you’re capping your max profit in exchange for the $200 premium received, and even though you could’ve made more, you still did very well.
If XYZ doesn’t reach $55 over the next 30 days, that $200 is yours to keep as income, which can be used to hedge against the stock trading down or just added to your bank as additional profits. For example, if XYZ traded down the $48, someone who only bought the stock would be down $200, but because you hedged your position by selling a covered call, you wouldn’t absorb any losses until the stock traded lower than $48.
Another example might be the stock traded up the $53. You would have $300 of profit from the stock movement, plus the $200 premium received for selling the covered call, for a total profit of $500.
By selling the covered call, as long as the stock doesn’t trade over $57, you will do better than the trader who only owns the stock. The stock trading up 14% over 30 days is certainly possible, but, it’s a low probability, and even if it does happen, you still profited handsomely.
This is why selling option premium is so powerful. It may not seem like a lot when looking at one contract over 30 days, but when you do this month after month across your whole portfolio, you could generate tens of thousands of dollars of extra income annually.