“You’ve got to be kidding, right?”
“Options are risky. They’re for professional investors or speculators.”
“Regular people can’t make money from options.”
These are familiar statements. I hear them all the time. It’s my mission to dispel these types of statements by providing you with the real deal.
It’s an uphill battle sometimes, but I am up for the challenge. Nothing gives me more satisfaction than proving the naysayers wrong.
Look, options are risky. I will be the first to admit that. But so are guns, knives and nuclear weapons… if they’re in the hands of madmen.
As long as you know what you’re doing, you can make a consistent stream of income from the options market, more than what you’ll make from a CD or bond. And you don’t have to take much risk. You just have to know the rules and the possible outcomes ahead of time and agree to them.
Yes, anyone can get 1% from a savings account or 2% from a CD. See how far that gets you in a world where stealth inflation is one of the biggest risks.
Let’s look at two ways you can generate consistent income from options…
First, we’ll look at the “safest” income strategy using options. These are covered call trades.
Guess why this is called the safest strategy? It’s because it’s safe for your broker! In a covered call trade, you already own the shares and you sell options against your shares to generate income.
You sell an option at a price above where your shares are trading. If your shares go over that price at or before expiration, the person you sold the options to has the right to buy your shares from you at the agreed-upon (strike) price. For entering into that agreement, you get paid cash upfront that is yours to keep.
People love this strategy because they can sell options at prices well above where their shares are trading and gain a consistent income stream. Let’s look at an example…
You own Merck & Co. (NYSE: MRK) shares. The stock is selling for $56. You sell the right to someone to buy your share at $65 in a year. The buyer will pay you $1.20 per share for that right. If you own 1,000 shares, that’s $1,200 in extra cash just for letting someone buy your shares $9 higher than where they are. If they don’t get there, you continue to own your shares. The $1,200 is yours regardless. The only catch is that you must have 1,000 shares of Merck or $56,000 in the game.
Now, let’s look at my favorite income-generating strategy: put selling.
With this strategy, you don’t own the shares but you want to – at your price. This is critical! I’m not saying just sell puts on any old company. I am saying sell puts only on companies that you want to own at your price.
So let’s look at the Merck example. You don’t have $56,000 tied up in the shares, but you would love to own the stock at $45. So you sell 10 put options on Merck that expire in a year at a $45 strike price – that’s 20% below where the shares are trading. This means you are obligating yourself to buy Merck at $45 if the shares close below $45 at expiration. That option is trading for $1.20 as well. You sell 10 contracts at $1.20 and pocket $1,200.
Instead of having to put up $56,000, you need only 15% or $6,750 (15% x $45 x 1,000 shares or 10 contracts) in collateral to do the trade. But if you do get the shares and you want them, then you’ll have to come up with the difference (the 85%) at expiration or at the time you get put the shares.
The $1,200 you received is yours to keep, just like in the covered call trade. The difference is that the money you don’t have to put up to own all the shares can now be used for other investments.
Let’s look at the returns. In the covered call trade, you made $1,200 on $56,000 in the market for a return of 2.14% for a year.
In the put sell trade, you stand to make $1,200 on $6,750 that you must post as collateral or 17.7%.
The question you must ask yourself is this: Do I really want to own Merck for $45 when it’s currently trading at $56?
I’ll give you one more piece of information… Based on my proprietary calculator, the chances of Merck falling to $45 at expiration is 14%. So there’s a 14% chance you’ll have to buy the shares at a 20% discount to the current price.