I have a very simple way for any investor to make more income using a very easy and less risky means of adding a few stock options to your portfolio.
Before you stop reading, I want you to know that I’m absolutely serious. You can increase your income and not have a whole lot of trouble or complex trading schemes. I’ll show you how to use stock options in their simplest and safest form, and I’ll give you some great examples.
You might have never done anything with stock options. Or you might have bought some and quickly regretted it — and for good reason.
Mention stock options, and most individual investors will either draw blank stares because they have never bought them or they’ll wince because they think stock options are only one-way recipes for losses.
There are very good reasons you might be in either group. Maybe you haven’t made the effort to better understand the benefits of stock options. Or perhaps you waded on into the market and quickly lost money for your efforts.
Way too many folks lose money on stock options because they buy them. And I never want you to ever buy a single stock option ever. That’s right: Never buy a stock option.
There’s a very good reason for not buying. From the moment you buy them, options lose value every second until they’re worthless at their expiration. But perhaps I’m getting ahead of myself.
Let’s look at the basics of options.
Options are securities that give the buyer the right to buy or sell a set number of stock shares in the market. Options come as either calls or puts. Calls provide the buyer with the right to “call,” or buy, shares at a specified price for a specified period of time. Puts give the right to “put,” or sell, shares at a specified price for a specified period of time.
Each option covers 100 shares of a stock, and they trade through any broker just like any other traded security.
The market sets up established dates for the expirations of calls and puts. Those dates tend to be throughout the year, typically coming due each month at the end of the third week.
The so-called “strike” prices, meaning the prices at which stock can either be called (bought) or put (sold), are also set up in the market, typically just below or just above the current market price for the specific stock — although some option prices can be well below or well above the current market.
The market price for a call or put is based primarily on three things. The first is any intrinsic value of the option. This means if the strike price for a call is below the current price for the stock, then the call would be said to be “in the money” and have intrinsic value equal to the difference between the strike price and the market price for the stock covered by the call.
For puts, if the strike price of the option is above the current market price for the stock, then the buyer would be able to sell the shares for more than the market. The puts would be in the money and have the intrinsic value of the difference between the strike and the market price for the underlying stock.
The second component for pricing options involves time value. The longer the term of the option, the more valuable the option is. So an option that expires six months from now is going to be priced more than one that is expiring this month.
The third component for pricing options involves the volatility of the market price for the stock. The more volatile the market for a stock is, the greater the value of the option to either control the buy price in a call option or control the sell price through a put option.
Don’t Buy Any Options
Too many investors wade into the stock options market by buying options. These investors lose money as the time value elapses and the options expire.
These investors will buy a call on the speculation that the price of the underlying stock will go up enough so that a call might rise in value and perhaps have some intrinsic value, meaning, like I mentioned above, the calls have a strike price below the market price for the underlying stock.
Or by buying a put, the investor will speculate the market for a stock that will fall enough and do it quickly enough for the puts to be worth something before they expire.
The trouble is that both of these strategies really are pure speculation that depends on stocks moving in short amounts of time and moving in large amounts in that short amount of time.
Other investors try to get involved in options after being pitched on various strategies of combining calls and puts with various titles, ranging from strangles to straddles to collars and the list goes on. Most of these are rarely fully understood, and results tend to be the same: liberating you from your money.
Instead, I want you to learn how to sell options, not buy them. That’s right: Sell them rather than investing in them.
Here’s the deal. You don’t have to buy puts and calls, as you can also sell puts and calls. And when you sell a put or a call, the market pays you the premium right up front. Then, if you sold a put and the stock goes down and the person who bought the put from you exercises the option, you must buy the stock at the agreed put price.
Or if you sell a call on stock that you won, you might have that stock called away if the market price goes above the strike price of the call option.
So, by selling a put on stock that you want to buy and own, you get paid to buy it at the price at which you want to own it. And for stock that you already own, you get paid by selling a call to sell the stock at a higher price in the future — a price at which you would be happy to sell.
Now, here’s where I put together puts and calls.
I like to start by finding a stock that I like and want to own. Let’s take as an example a stock that I’ve written about before, SeaDrill Limited (SDRL), which I last write about on June 19 in Your Ship Has Come In. SeaDrill, an offshore drill rig company that’s very operational and financial risk-adverse, pays a nice, big dividend of more than 8 percent.
Now, the stock price is about $40. That’s a good price for this stock that I think could go higher. But rather that just buying it, you can get paid up front to buy it at a cheaper price.
You can sell puts with a strike price of $38 and get paid about $1.25 per share to do it, with an expiration of Oct. 19. That means that for each put option, which covers 100 shares, you’d get paid $125 to potentially be put the stock at a price of $38 a share — $2 less that it’s trading for right now.
If in October the stock price is $40 or more, you don’t have to do anything. You keep the $125, and you can do the same thing all over again for the next few months. But if the stock dips a couple or more bucks, you get to buy it if you’re put the shares at a cheaper price. It’s like being paid to put in a limit price to buy the shares.
Now if you do get put the stock, that’s great; you’ll own a great stock with a great dividend. But it will get even better. Because once you own the stock, you can turn around and sell calls on the stock.
So again, let’s say you own SeaDrill. You can sell calls for October expiration at a price of $42, $2 more than it’s trading right now, and get paid $1 or more a share. If the stock goes nowhere or dips a bit, you will still own a great stock and get a great dividend, and you can turn around and sell another call on the stock for the following months.
Or if the stock goes up and your stock gets called away, that’s great. You made $2 more on the stock and you also get to keep the extra $1 a share from selling the call.
And you can keep doing this over and over again.
Start with a great stock that you want to own. Sell a put at a strike price below the current market. Then if the stock doesn’t get put, do it again. If the stock does get put, great; turn around and sell a call. If the stock gets called, that’s great; turn around and sell another put.
It’s that straightforward.