Generating income is one of the most significant challenges that investors face.
Interest rates have been unusually low since the Global Financial Crisis of 2008 to 2009, and any hopes to increase rates have largely been dashed by the COVID-19 pandemic. The latest global economic shock has dashed any hopes that investors may have harbored that monetary policy would normalize and that rates would rise and investment yields would return. For the foreseeable future – a period that could last for several years – it will likely be difficult for anyone to earn meaningful yields on bonds without taking on great investment risk.
Yet, a potential solution exists for investors who are comfortable using options strategies that are designed to enhance the yield of stocks. Many people associate options trading with risky investments, but that misconception largely reflects the media attention that is given to speculators. Because options can be used to potentially make a lot of money while putting up only a small amount, some investors make wild-eyed trades because they have heard investment charlatans talk about mythical triple-digit returns.
What is often overlooked, even though it is within the grasp of many investors, is using options to create income with more conservative strategies. Selling options against stocks that an investor owns, or wants to own, is a popular method for generating incremental income and enhancing stock returns. Investors can think about selling puts and calls as generating a “conditional dividend.” What is the condition? That the investor is willing to buy or sell the stock if it is below or above the call or put strike price at expiration.
Before we delve into the nitty-gritty of this income-generating strategy, it’s important to define terms. The options industry uses a lot of different words to basically describe the same, or similar, ideas.
Everything starts with puts and calls, the building blocks of the options market.
Puts and Calls
A “put” gives an investor the right to sell a stock at a certain price for a limited period of time. Conversely, a “call” gives an investor the right to buy a stock at a certain price for a limited period of time. To generate income with options, we don’t buy puts or calls—we sell them. And we sell them against stocks that we already own, or stocks we want to buy.
Most people buy stocks because they think their prices will increase. The natural position of many investors is thus said to be “long.” If they were “short,” they would be betting on declining stock prices, a highly risky strategy. Instead, investors often buy puts to offset the risk that their stocks will decline. If stock prices decline, put prices generally rise.
Subsequently, this often means that put premiums are more expensive than justified. We don’t need to granularly discuss options’ volatility and pricing dynamics but be aware that persistent demand for puts generally creates a “fear premium” in varying degrees at various times.
Call prices usually do not trade with the same kind of premiums as bearish puts. They can, and do, trade with a “greed premium,” but for the most part calls are often reasonably priced. Just as with stocks, most people buy calls because they think stock prices will rise.
Other investors, however, like selling calls to generate income or to monetize higher price targets. For whatever reason, fewer investors sell puts even though, like buying calls, it is another way of taking a “long” position in a stock. It can be riskier if done improperly, and it usually requires more money upfront—but it is a way to capture the “fear premium” and that makes selling puts an attractive strategy to consider.
Deciding if you will sell calls or puts largely depends on your goals. If you want to potentially buy a stock at a lower price, sell puts. If you want to potentially sell a stock at a higher price, sell calls. Both trades can generate income and enhance returns. The amount of income is limited to what you receive for selling the option.
Now that we have established those bedrock facts, let’s address the jargon.
When you sell calls against the stock, you are using a “buy-write strategy,” or a “covered-call strategy.” Both terms basically describe selling a call against a stock position. The buy-write strategy refers to buying stock and simultaneously selling a call (Where does the “write” lingo come from? Before options were electronically traded, brokers wrote out contract specifications on paper contracts.). The covered-call strategy describes selling an option against stock that you already own.
When you sell a put, you are agreeing to buy a stock at the put strike price. If the stock price declines, and the put is assigned, you will be required to pay for the shares with cash (either the cash you have on hand, the cash raised through the sale of securities, or cash borrowed from your broker.). A “cash-secured” put involves pre-funding a potential stock purchase by depositing the money, which you would otherwise spend to buy a stock, into a brokerage account and then sell a put. The put is thus “secured” by the cash.
Now, let’s focus on two strategies that are widely used: selling calls against stocks you own and selling puts against stocks you want to buy. Following are examples of the covered call and the cash-secured put strategies.
The covered-call strategy is often used by everyone from mutual fund managers to individual investors. It’s popular with money managers who tend to have price targets on every stock that they buy. In other words, smart investors have already set a sale price when they buy a stock. If they bought a stock at $20, they could have a $30 sale price. In that example, they would systematically sell $30 strike calls against the stock to enhance income— and get paid for owning the stock.
With so many expiration dates to choose from, which is the “best” for selling covered calls? We believe that options with up to two months to expiration offer the best liquidity and provide multiple opportunities per year to reset target prices and generate income.
A standard income-generation trade is selling options that expire within two months and that have strike prices that are 5% to 10% higher than the current stock price. Other investors sell calls that expire weekly, reasoning that they can make more money repeatedly selling calls, but that is an approach best left to more seasoned traders.
It is important to understand that you may miss out on a big rally if you sell calls against a stock. This is the principal drawback of the strategy. In the market, anyone who has a hot stock called away from them is said to experience “upside regret.”
(There are ways to mitigate that regret, but that’s a discussion for another day.)
When you sell a call, you are essentially saying that you do not think a stock price will rise above the call strike price. In other words, you think the associated stock is stalled and unlikely to advance. Sometimes this works out beautifully, and you can keep the money that you received for selling the call and collect a nice income.
Now, let’s flip this whole equation around.
To us, there’s nothing wrong with selling calls. It’s probably how many investors get their feet wet in the options market, but selling puts can be appealing to investors who are disciplined and well-capitalized.
Selling puts can let investors monetize the fear of other investors. It is such a seductive strategy that many pension funds and major institutional investors often sell puts to generate income. The risk—which can be managed—is that you must be willing to buy the associated stock if the price drops below the strike price. If you sell a put with a $30 strike price, and the stock falls to $10, you must buy the stock at $30 or cover the put—that is, buy it back at top dollar.
When you sell a put, you are essentially saying that you do not think a stock price will decline. In fact, some strategists believe that selling puts is the single most bullish options trade that exists. Why? Because you only sell puts when you think a stock will rally, or if you are willing to buy the stock if it declines below the put’s strike price.
Sometimes this works out beautifully, and you simply pocket the money that you received for selling the put and collect a nice income. But sometimes the unexpected happens—and this is why you should never sell put options on stocks you are not willing to buy. Sometimes, the stock that you thought was ready to rocket higher actually rockets lower. If this happens, you have two choices: You can simply let the stock be “put to you,” and buy shares at the strike price, or you can buy back the put. If you buy back the put, its value will likely have increased, perhaps dramatically, because the put is suddenly in the money.
For this reason, many investors think that selling puts is incredibly risky. They are not entirely incorrect because when a put is assigned a large amount of cash – relative to the put premium collected – must be available to buy shares of the stock or buy back the put. However, by selling “cash-secured” puts, you ensure that there is sufficient cash in the account at all times to cover any sudden purchases that may be needed.
Without a doubt, each strategy has native advantages and disadvantages, but both share this: by selling puts or calls, investors often can generate income, or enhance the yields of their stocks with defined risk.
On March 6, sold June 50 strike CVS puts for a credit of $1.20 per contract.
If the stock were to drop to $50 by September expiration, stock could be purchased at a 34% discount relative to the prior YTD high.
If the stock were to advance, the income is retained.
Source: Yahoo Finance
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