In my last post, I introduced the basics language of options. In this post, I’ll share some simple options strategies to produce income. Options are thought of as focused on capital gains. Capital gains are when you buy something and sell it for a higher price. Options are a good way to generate income, too.
Strategy #1 Covered Calls
For both strategies, I am going to use Pfizer’s option data. I do not own any Pfizer, and nothing in this post is investment advice. Pfizer is a well known and reasonably priced stock.
What the above tells us is Pfizer’s stock symbol is PFE. PFE trades on the New York Stock Exchange. The last price was $36.57 to own or sell one share. Most option contracts revolve around 100 shares per contract. There are mini options that involve 10 shares. They are not as popular. The 100 share option contracts have the most people buying and selling them.
Please click on the above to see the options available and their prices. Let’s say you own 100 shares of PFE at $36.57 each and are not optimistic about how PFE performs over the next year. You don’t think Pfizer stock will make it above $40. If Pfizer goes above $40, you are okay with selling it at $40 to someone else. This is a perfect use of a covered call. You own 100 shares of Pfizer stock, and sell 1 call at $40. By doing this, you get $2.10 per share, or $210 total ($2.10 x 100 shares, see the first column on the left, half way down). It’s called a covered call, because the call is covered from risk by the underlying 100 shares.
There are two scenarios. Let’s say PFE does nothing much over the next year, and right before the January 2022 expiration, the stock is at $39.99 per share. The option will expire, which means that the contract is no longer valid. You keep $3.42 per share in capital gains ($39.99 is the current price – $36.57 the price you bought the shares). Since you own 100 shares, your capital gain is $342. That’s good. We forget we got $210 from each share from selling a covered call. That money is ours to keep. That boosts our total return to $552.
| PFE Share cost x 100 shares (A) | $3,657 |
| Capital gains (B) | $342 |
| Covered call income (C) | $210 |
| Capital gains return on investment (B divided by A) | +9.35% |
| Covered call return on investment (C divided by A) | +5.74% |
| Total return on investment (B and C together divided by A) | +15.09% |
I don’t know about you, I consider more than 15% in a year an excellent return. Remembering the Rule of 72, if we earned 15% every year, our money would double in about 4.8 years.
In Scenario 2, the price of PFE stock is above $40 a share. Let’s say the stock closed at $41 a share. Since the price of the stock is more than the price of the option ($40), the option will be exercised. That means the person that bought the option will exercise their right to buy 100 shares from you at $40. They can sell the shares on the market the next day for $41, making a $1 profit per share, or they can hold on to their shares, speculating on future gains. Once the option is exercised, you will sell them $100 shares at $40 each. In return, they will provide you $4,000 in cash. You still keep the $210 from selling the option, and now have a total of $4,210 cash in your account.
| PFE Share cost x 100 shares (A) | $3,657 |
| Capital gains (B) | $343 |
| Covered call income (C) | $210 |
| Capital gains return on investment (B divided by A) | +9.38% |
| Covered call return on investment (C divided by A) | +5.74% |
| Total return on investment (B and C together divided by A) | +15.12% |
| Cash in account (A + B + C) | $4,210 |
| Shares sold to buyer | 100 |
| Opportunity lost from option exercise | -$100 |
This is how the profit graph looks like for selling a covered call.
Strategy #2 Bullish Put Spreads
A bullish put spread is when you buy one put at one price, and sell another put at a lower price. You are looking to capture the premium between the two put options and limit your financial exposure. In a bullish put spread, you might sell the $30 put and buy the $28 put. You are betting that the price of PFE stock stays above $30 when January 21st, 2022 comes around. In case you are wrong, you buy a $28 put to limit your losses. What this means is you will buy 100 shares from someone else at $30 per share, if Pfizer stock price is below $30. If thing go badly, you are willing to sell 100 shares to another person for $28 per share. Unlike covered calls, you don’t have to own the underlying stock to use spreads. The price of the $30 put is $1.43, and the price of the $28 put is $0.95. Let’s sell one put spread and see what it looks like.
| PFE Share cost x 100 shares | $0 |
| Revenue from selling $30 put (from the middle, first column on the right, 7 rows down) | $143 |
| Cost from buying $28 put (from the middle, first column on the right, 6 rows down) | -$95 |
| Potential profit (A) | $48 |
| Potential loss (stock is lower than $28 at option expiration) (B) | -$200 |
| Put Spread potential return on investment (A divided by -B) | +24% |
A potential return of +24% is good. If we guess wrong and Pfizer stock ends below $28, it could turn into -76% loss ($48 gain from premiums minus $200 loss added together, divided by $200 money at risk). Ouch!!! That will wipe out your money slower than going to Vegas, but wipe it out regardless.
If we sold 10 put spreads, our potential gain is $480, and we have $2000 at risk. We’d be spending less than buying 100 shares of PFE stock, with potential for much higher or lower returns. This is called leverage. For the same amount of money, you can earn a higher or lower rate of return, compared to more normal investments. A common form of leverage is putting down 10% on a house as a deposit and taking a 90% mortgage if you hope to flip the house. You are hoping the house price increases fast enough for big profits based on your small investment. If you put down 20% as a deposit, it’s easy to see the house price would need to go up more to get the same returns. Same concept applies to put and call spreads. You are leveraged in comparison with buying the actual stock.
Here is how the profit loss of a bullish put spread looks like for our PFE example:
Both of the above are two strategies I use in our own accounts to generate income.
What’s the catch?
Almost nothing in life is free. Many of you may be wondering the returns sounds too good to be true. They are not, the returns possible are very real. There are four gotcha’s you need to know about.
- Options are usually not taxed at lower capital gains rates. Instead, they are taxed at ordinary income tax rates. Please consult with your tax professional for more details. That makes selling options in Roth IRA’s more powerful, where you can generate income tax-free.
- Paperwork at tax time can be painful. Because of the complexities involved with options, it takes an experienced tax professional to interpret the statements given to you by your brokerage firm. Any IRA avoids these headaches.
- Options involve leverage, it’s too easy to bet on a sure thing, only for the sure thing to become the opposite, and you get wiped out. Take small positions to start, and increase slowly over time. Greed is your financial enemy.
- If the option turns against you, and you need to close out your position, depending on the option and stock, it may be very difficult to find someone to take the option off your hands. This is known as liquidity risk. Someone may not be available to transfer the position, or the cost for doing so may be high. I recommend using options on stocks that are easy to get into and out of a position. Usually well known stocks won’t have any problems with liquidity.
- Last, behavioral finance tells us that the more we trade, the lower our returns. Focus on good setups, trade less frequently, be less emotional. With options, you can quickly scale to amounts that are not good for your mental and physical health. If your emotions get involved, I 100% guarantee you will make bad decisions at the worst times. All this comes from practical experience from someone having lived through bad financial decisions. A loss of confidence is worse than losing money. You can recover from the second, but the first is difficult to overcome.
Thanks for reading. In our next part, I’ll discuss how to open a brokerage account, fund it, and set up your first option trade. There are many more options strategies available. I found the effort involved in tracking these complex strategies made my head spin. Keep it simple. Focus on what you need to reach your goals. Happy investing! Below is the spreadsheet I used to generate the charts in this post.
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Thanks for reading!
Warmest regards,
smilingdad
smilingdad 