Generating income while waiting for share price to move

[bdsjp]

Hello, I want to share a common but effective options strategy with you. Don’t let the word “options” scare you off. This strategy is simple and easy to pick up, best of all, it gives you a consistent flow of income every 30 to 45 days.



Take Apple Inc. (APPL) as an example, this stock is trading at around $149/- today. Let say we want to buy the shares of Apple but not sure will it drop in the next 1-2 months. If it drops to $145/-, we will definitely be interested. So, most people will either buy the shares at $149/- or wait for the share price to fall but not us!



We will sell a Put option at $145/- strike price with expiration date 20 Aug’21, and collect a premium of $330/- (100 shares X $3.30). Effectively get paid while waiting for the share to drop to $145/-.



If by end of 20 Aug’21, Apple share stays above $145/-, we don’t get to buy the share but will keep the premium of $330/-. Not bad, $330/- just for waiting!



If Apple share say drop to $144/-, we will still buy the share at $145/- and keep the premium, effectively reducing the cost of the purchase to $141.70.



The real risk here is when Apple shares drop to zero and we still have to buy the shares at $145/-. So, choosing a good company where the share price is stable is important here.



So, if we are more keen to collect premiums than buying the shares, what should we do?



Well, we can sell the Put at a lower strike price of say $135/- and collect a premium of $106/- ($100 shares X $1.06), assuming that Apple share price don’t drop below $135/-.



Important: Please note that you need to have enough cash to buy the shares. In our example, it will be $14,500/- (100 shares X $145/-)



   

(Please refer to the below Yahoo finance link on the options chains if the picture did not appear. Note that premium pricing changes when market open.) https://finance.yahoo.com/quote/AAPL/opt...addle=true



Now let say Apple share price drop to $144/- and we brought the shares at $145/-, what should we do 😊 We can sell a Call option at a higher strike price (say $150/-) and collect premium ($465 = 100 shares X $4.65) while waiting for the shares price to move up.

You can just use this 2 steps strategy to generate consistent monthly income.

What type of stock to look out for, when will be a ideal price to enter the trade, what strike to sell the Call option, trade management etc. are explain in the kindle book (Turning The Wheel) listed on Amazon.

[Wildreamz]

Selling covered Puts and/or Calls is a pretty common strategy. It's a process that can be automated via buying Covered Call ETFs (https://www.etf.com/channels/covered-calls).

That said, they generally underperforms their underlying (https://www.moneyshow.com/articles/optionsidea-41063/). As with all things in finance, there is always a trade-off (reduced volatility <-> less expected returns), there is no free lunch.

From personal experience, I've made money with covered calls/puts, but I'd have done much much better if I had just bought the underlying and call it a day, lol.

[Kaimin]

Covering calls and selling puts is not as optimal a strategy as it is sometimes sold to be. There are similarities with convertible bonds, which often use the more complex rules to mask its risk and focus on its upside. The same goes for such option strategies, which largely uses complexity to make its downside look uncertain but upside guaranteed. 

For your strategy of selling puts, you profit from the premium but it costs you your strategic position in the market. Keeping the capital in cash to cover the put keeps you out of the market, if the stock takes off you will miss it. If the stock plummets, it is not a disaster if your fundamental analysis is correct and the strike price is not overvaluing the stock. But the insidious part of the argument is claiming this is not a loss at all because you would've bought the stock at an even higher price a month ago. The strategy has put you in an unfavorable strategic position, it has an opportunity cost. It becomes more obvious if you keep paying this opportunity cost, you would never benefit from any rise in the stock price.

The covered put strategy has a similar cost. It puts you in an unfavorable strategic position that could see your stock disappear for a slightly higher price than you bought but forces you to eat all the losses to maintain t. It half borrows the argument from value investing that a drop in stock price doesn't matter. But that argument is only valid in the context of a value investing strategy because you can take the downside for an even larger subsequent upside. In this context, which is really a trading strategy trying to put on a mask of value investing, it is a real cost because you would never have any multibaggers but will eat a lot of paper losses. It too has an opportunity cost.

Like convertible bonds it depends on the prices involved. With selling puts its about valuing the strategic position you're giving up. If you sell puts when the premium is 40% of the stock per annum this is more than you could reasonably expect to make buying it straight long. Here there's a very good case for doing this because there is large margin of safety. Even if the strike price is hit and plummets 40% further you still have not even a paper loss. You would own 100% of the stock you were intending to buy a year ago and another 40% in cash. If you ploughed that back into stock, you'd actually end up owning 167% of the amount of stock you initially could buy. 

If you're covering calls, a 40% premium with a strike price 10% above the current market price means you're going to make a lot of money before incurring an opportunity cost, so there's a very good argument here.

But as with all investments it depends on circumstances specific to the prices. The very useful information Wildreamz provided shows in practice selling options is not as profitable as some people make it to be. It is undoubtedly profitable at some point, as with any investment the question is judging the price at which it is.

[Wildreamz]

I guess, in rare cases where the underlying trades sideways for extended periods of time, this strategy can be potentially useful. e.g. Disney.

I heard some fellow Tesla investors also sold covered calls and puts frequently due to it's high volatility (hence, higher premiums) and traded sideways for many years before the bull run in late 2019. Conversely, if they continued to do so through 2020-2021, they would have missed all of the upside.

[weijian]

It all comes full cycle.

In the lead up to GFC2008, folks were making consistent "safe" money selling insurance (the person who buys a put option is basically buying insurance). The poster child would of course be AIG who had underwritten CDS (credit default swaps) to the eventual big winners of the crisis. Of course, what AIG did wasn't wrong, it was part of their business model to assume risk. The thing that took them down under was their act of underestimating the risk and pricing their "premiums" to cheap.

And now in this great bull market, we are back to having the OPMI selling put options - very similar to selling insurance as AIG did. Well, then again, nothing wrong with this act - It is like a regular stream of dividends and which OPMI doesn't like it? If the bull market continues, I earn "free money". If things go against me, heck, I get a stock I "like" and if it drops further, I will HODL for the long term. The OPMI will be psychologically pleased with himself.

[Wildreamz]

It all comes full cycle.

In the lead up to GFC2008, folks were making consistent "safe" money selling insurance (the person who buys a put option is basically buying insurance). The poster child would of course be AIG who had underwritten CDS (credit default swaps) to the eventual big winners of the crisis. Of course, what AIG did wasn't wrong, it was part of their business model to assume risk. The thing that took them down under was their act of underestimating the risk and pricing their "premiums" to cheap.

And now in this great bull market, we are back to having the OPMI selling put options - very similar to selling insurance as AIG did. Well, then again, nothing wrong with this act - It is like a regular stream of dividends and which OPMI doesn't like it? If the bull market continues, I earn "free money". If things go against me, heck, I get a stock I "like" and if it drops further, I will HODL for the long term. The OPMI will be psychologically pleased with himself.

To be fair, I don't think it's much riskier than simply holding the underlying. As you can close out your put/call position anytime (similar to selling the underlying at a loss, after the price has fallen). In fact, I think the downside risk is almost certain to be less than the underlying. My issue is mainly with the capped upside. If the market goes up too quickly, if you are lucky, you could "roll" to a later date, but most of the time, you are called out of your position, and have to buy back in at a higher price.

It's at best a low-volatility trading vehicle, with low expected future returns.

[corydorus]

I am wondering who is buying those Put Options, if the issuers are earning so well from the premium. Someone has to be stupid at the end of the day. Who ? Who ?

[weijian]

It all comes full cycle.

In the lead up to GFC2008, folks were making consistent "safe" money selling insurance (the person who buys a put option is basically buying insurance). The poster child would of course be AIG who had underwritten CDS (credit default swaps) to the eventual big winners of the crisis. Of course, what AIG did wasn't wrong, it was part of their business model to assume risk. The thing that took them down under was their act of underestimating the risk and pricing their "premiums" to cheap.

And now in this great bull market, we are back to having the OPMI selling put options - very similar to selling insurance as AIG did. Well, then again, nothing wrong with this act - It is like a regular stream of dividends and which OPMI doesn't like it? If the bull market continues, I earn "free money". If things go against me, heck, I get a stock I "like" and if it drops further, I will HODL for the long term. The OPMI will be psychologically pleased with himself.

To be fair, I don't think it's much riskier than simply holding the underlying. As you can close out your put/call position anytime (similar to selling the underlying at a loss, after the price has fallen). In fact, I think the downside risk is almost certain to be less than the underlying. My issue is mainly with the capped upside. If the market goes up too quickly, if you are lucky, you could "roll" to a later date, but most of the time, you are called out of your position, and have to buy back in at a higher price.

It's at best a low-volatility trading vehicle, with low expected future returns.

I don't think there is anything wrong, or it been more risky. Frequently, the vehicle isn't much of the risk but it is the behavior that is.

The risk comes from not knowing what you should know - For this case, (1) understanding what this strategy is truly about (ie. who is your counterparty and why are they paying you premiums), (2) about pricing it correctly and (3) knowing that eventually owning the stock, is NOT the end desired result for this strategy.

As the saying goes, what the wise man does at the beginning, the fool does in the end.

[donmihaihai]

Remind me of the late 1990s. Tech co. Selling call and put options of their own shares. These tech co. Made lot of money until market turned against them.

Co. Such as Dell and Microsoft..

[Kaimin]

I heard some fellow Tesla investors also sold covered calls and puts frequently due to it's high volatility (hence, higher premiums) and traded sideways for many years before the bull run in late 2019. Conversely, if they continued to do so through 2020-2021, they would have missed all of the upside.

At the amazing premiums the market is paying for options now you're still going to get a lot of upside before you lose out. 

Currently Google calls lasting one month with a strike price 4% above the current market price are selling at 3% of the current market value. In other words the price of Google would have to rise above 7% in one month for me to lose out. Annualised that's a 125% gain. Even if it does I'm still making a huge amount of money. But because of volatility, lets say it only rises above 7% for 6 months, the other 6 months the stock dips 3%. That's still a 50% gain.


Likewise you are shielded from 3% of downside a month which is a lot of protection. I'd say that at the surprising prices right now, the risk/reward ratio is favorably symmetric if you pick a good stock. In the long run a covered call strategy is as profitable as its underlying security.