I mentioned several times in the past few months that I’m trading options as an additional way to generate income from my portfolio. In this case option income.
I’ve noticed that this sparked interest in several of my followers. However, most of them mentioned that they posses limited knowledge about investing in options. This therefore prevents them from being able to generate additional income from their portfolio.
This is the reason why I will try to clarify my own strategy as an inspiration to you. My aim is to do this in an easy to consume manner.
I do realize though that I will not be able to proactively think about every question that you might have. Therefore my ask to you is to please leave your question in the comment form below. Your questions, and subsequently answers from me and the wider community, could be a great extension to this blog post for any future readers.
Without further ado, let’s get into it 👇
A very brief introduction into Options
– Call Options example
– Put Options example
Option Income Strategy #1 – Get paid to wait
– Risks to this Option Income Strategy
– But what if the stock price crashes and fundamentals have changed?
Option Income Strategy #2 – Speculating on a rebound
Final Thoughts & Conclusion
A very brief introduction into Options
Let’s start with a very brief definition and introduction into options. This should set the context for my option income strategy in this post (related to stocks, not i.e. currency trading).
“Options are financial instruments that are derivatives based on the value of underlying securities such as stocks. An options contract offers the buyer the opportunity to buy or sell—depending on the type of contract they hold—the underlying asset.”
Hence, an option is a right (not a duty!) to purchase or sell shares at a predetermined price when the option expires (or even before). Having said that, an option typically consists out of five components:
- Contract size: i.e. 100 shares
- Underlying Value: i.e. $1.00
- Option type: Call or Put
- Strike Price: i.e. $25
- Expiration Date: i.e. 18-Sep-2020 (usually the third Friday of the month)
Thus there are two kind of options:
- Call options: It gives the holder the right to purchase shares at a predetermined price (strike) at a certain expiration date
- Put options: It gives the holder to right to sell shares at a predetermined price (strike) at a certain expiration date
Investors typically buy call options if they believe that the price of a share will be higher in the future than the option strike price. Therefore they are willing to pay a small premium upfront to reserve the right to buy at that price.
Investors typically buy put options if they believe that the price of a share might be lower in the future than the strike price. It is often used as a way to protect your portfolio against downside risk (i.e. 10 market correction). Or to speculate that a stock might drop in share price. Therefore investors are also willing to pay up a small premium upfront for this.
Let’s further explain this based on 2 examples.
Call option example
Ahold Delhaize has a current share price of 24.95 Euro. Let’s assume that you are very convinced that Ahold will be worth 27 Euro by the end of this year. You don’t want to buy 100 shares for 2495 Euro right now. You simply don’t like to spend so much money on a single trade. But you would like to benefit from the potential gains between the current share price and your target price of 27 Euro (205 Euro potential gain).
In this case you have the “option” to buy a call option with a strike price of 26 Euro at an expiration date of 18 December 2020 for 0,68 Euro (68 Euro for the full contract).
So let’s assume it’s 18 December 2020 now and the share price is indeed at 27.00. In this case you would’ve made a 32 Euro profit (27.00 – 26.00 (strike price) – 0.68 (option price) = 0.32 (* 100 shares). You could argue that you made a 47% profit in just a 5 month period. This is excluding transaction fees.
However, if the share price would stay at around 25 Euro, then you would have effectively lost the full 68 Euro. Hence why I consider such a strategy speculation. Which is OK for me though as long as you’re making a conscious decision that you can lose the premium.
The break-even point would be a December 18 price at 26.68. In that case you would’ve neither made a profit, nor a loss (except for the transaction fees).
Put option example
Let’s assume that you think that Ahold Delhaize is currently very overvalued. You believe that the share price will be below 22 Euro by 18 December. You are willing to speculate and make some money on this trade.
In this case you have the “option” to buy a put option with a strike price of 23 Euro at an expiration date of 18 December 2020 for 0,75 Euro (75 Euro for the full contract).
So let’s assume it’s 18 December 2020 now and the share price is indeed at 22.00. In this case you would’ve made a 25 Euro profit (23.00 – 22.00 (strike price) – 0.75 (option price) = 0.25 (* 100 shares). In this case you could argue that you made a 33% profit in the same 5 month period. This is also excluding transaction fees.
However, if the share price would stay at around 25 Euro, then in this case you would have also lost the full 75 Euro. The break-even point in this case would be at 22.25 Euro.
Note: in both cases the option price is heavily influenced by the volatility in the underlying stock. Prices tend to be lower in a low-volatile environment and higher in a high-volatile environment. This is my opinion an important variable to understand when trading options.
I hope this gives you a basic understanding of using Call and Put options.
Would you like to learn a bit more about trading options?
Having said that, option trading becomes very quickly complex for novice investors. I would like you to understand that I’m probably only covering 5% of the available option strategies out there.
In case you are wondering, I will neither use terms like “short” or “naked” and such. To me they mean nothing more than traders jargon and I just find them confusing. Hence I’ll rather focus on explaining the risks associated to one of my option income generating strategies.
Now that we’ve got the basics behind us, let’s look at 2 strategies that I use to earn additional income.
Option Income Strategy #1 – Get paid to wait
The option income strategy that I’m using the most is selling put options at prices which I would like to own a stock. By selling Put options I’m obliged to purchase stocks at the predefined strike price. Via this approach I’m getting paid an option premium while waiting for the stock price to reach my buy price.
Let’s describe this strategy via an example.
Imagine again that my fair value estimate for Ahold Delhaize is 23 Euro. However, I would like to own this stock with a 10% margin of safety. In such case my ideal buy-price is 20.70 Euro (90% * 23 Euro)
So let’s assume that I would therefore be willing to purchase 100 shares at 21 Euro (just to round the number up to find an equivalent option with such strike price). The current price for such option is 0.35 Euro (35 Euro).
In this case I would sell 1 put option for 0.35 Euro. This means that I’m obliged to purchase 100 shares at 21 Euro (total costs of 2100 Euro). In other words, I would receive a premium which compares to a
dividend yield of 4,00%.
(35 Euro / ((5 months (=18 December 2020 - today()) / 12 months) * 2100 Euro) = 35 Euro / 875 Euro)
However, there’s a catch to this and it’s called Margin.
This is due to the risk associated to this trade (you could lose 2100 Euro). Hence, your broker will want you to keep some money on the side as a protection (margin). Depending on the underlying stock it is between 20% – 30% of the underlying obligation (strike price) under normal circumstances.
In the case of this trade I would have to set 423,75 Euro aside (~20% margin).
So let’s get back to the 35 Euro premium that we collect with this trade. You could argue that this investment would generate a Return on Investment of 8.26%. This is not annualized but based on the upcoming 5 months (35.00 / 423.75 = 8.26%).
Either way, a 4% annualized yield or 8.26% investment is not that bad. Especially not as an alternative approach to generating additional portfolio income from selling put options.
Risks to this option income strategy
But let’s talk about risks for a moment. As touched upon earlier, the main risk with this strategy is that I could lose 2100 Euro. The only case that I can imagine is if Ahold Delhaize goes bankrupt in the intermediate 5 months.
Although I give this a low probability, it is always a possibility. Therefore this is very much a test to your risk appetite.
As I mentioned before, I try to keep things simple in my mind.
I just think that I would like to own an additional 100 shares of Ahold Delhaize right now if I could purchase them at 21 Euro per share. Therefore this risk would always apply to positions in my portfolio anyway.
If the company indeed goes bankrupt in the upcoming months then I would’ve lost 2100 Euro. This is no difference if I would’ve purchased the shares instead of options. Therefore I treat this as regular portfolio risk. Being diversified in 40 stocks limits my exposure to “single stock risk”.
A related risk and probably a bit more nasty is to get margin calls from your stock broker. Usually at a time when you need cash the most. This typically happens when the markets are crashing. What this means is that you will have to put more cash aside (margin) due to the increased volatility and risk associated to your option positions.
The broker will therefore ask you to deposit additional money or to close your position at usually a big loss.
Again, this is not an issue for me. My war chest provides me ample room to increase my margin. However, if you are limited in cash-on-hand then I would recommend you to think twice about using this strategy.
But what if the stock price crashes and fundamentals have changed?
Actually this has happened to me back in February. I sold some Exxon Mobil put options with a strike price of $50.00 and an expiration date of 19 June 2020 at a price of $1.00 (100 dollars in total).
We all know what happened at the time with the Saudi’s starting an oil price war. On top of that we got a worldwide pandemic effectively putting the world to a hold. A real cherry on the cake!
Exxon Mobil tumbled and quickly started to sell for less than $40.00 per share. Way below my anticipated strike price based on my former Fair Value calculation of $60.00 per share. I have adjusted it accordingly to $45,00 per share.
So what I’ve done at the time is to not directly buy back my put option. That would’ve been very expensive (~$1500.00 back in March).
I realized at the time that the stock market was crashing during a panic sell-off and I also knew that I had still 3 months until the expiration date.
So in this particular case I just decided to wait (🥵 while sweating haha). I just let the price find a bottom and stabilize, which it did in May around $45.00 per share.
This gave me way more comfort and the question became now: do I want to own the Exxon Mobil shares at $50.00? The answer was No.
Therefore I waited until June with my decision and 1 week before the expiration date the stock was still hovering around $46.00. So on 12 June I pulled the trigger and bought back the “XOM June 2020 – $50” option for $4.00 ($400). I also sold a new put option for $4.23 ($423) at a strike price of $45.00 and an expiration date of 18 September 2020.
Note: the longer the expiration date out in the future, the higher the premium for an option (time value of money). Hence why this trade has “zero-impact” on my realized gains.
Having said that, with this approach I have effectively lowered my obligation to buy the shares from $50.00 to $45.00 which is in line with my fair value estimation. I have also prevented taking a loss back in June by postponing my decision until September.
In theory I can keep doing this in continuum. However, that makes no sense to me as there is an opportunity cost related to it (I can simply allocate the money (locked due to margin requirements) to buy other stocks).
All in all, so far with the option price of today at $3.55 (XOM Sep 2020 – $45) I’m having an unrealized loss of $255.00. If the price of the stock recovers to above $45.00 by 18 September, then the profit of this trade will be $100.00 over a 7 month time span. Alternatively I would purchase 100 shares of Exxon Mobil at a yield on cost of 7.7%. Either way I would be satisfied with that.
I personally use this getting paid to wait strategy the most. Year-to-date it has gained me 627 Euro in realized gains. I have currently ~385 Euro in unrealized gains (this includes my $XOM option).
I am so far quite happy with this result. Especially knowing that this has been a very volatile market.
An alternative consideration to this option income strategy
I think it is important to mention that the option premium becomes less when the gap with the current market price of the stock increases (aka out-of-the-money). This is because the likelihood of the price dropping more than 10% in the upcoming few months is relatively lower than that it stays around the current price.
Therefore, alternatively you could opt for an option with a strike price closer to the current market price. This can be a more lucrative strategy in a bull market (10+% option income yield) when the stock prices tend to go up and up. Especially if you have limited funds today to buy more of the stock.
In such case you could also write a put option for Ahold Delhaize at 25 Euro (in-the-money). You would collect a much bigger premium while you anticipate that you might never need to purchase those shares. Prices can only go up right? 🙄
I am not using the latter approach, because I generally have some funds available to purchase right away. I also find it a less conservative approach to option trading. The issue I usually have is that stocks are too expensive and trading above my fair valuation. Hence why I buy options typically at a 10% to 20% below the current share price.
Option Income Strategy #2 – Speculating on a rebound
This is an option income strategy which allows you to speculate on a rebound for a very undervalued stock at “zero-cost”. This strategy is a combination of two trades:
- Sell a put option
- Use that money to buy a call option
Let’s use an example again to further explain this strategy. Let’s assume again that you think that Ahold Delhaize is very much undervalued today at ~25 Euro. Like it was in September 2017 at 16 Euro. In that summer there was an external event (Amazon buying WholeFoods) and suddenly the market narrative was that Amazon will wipe out all the supermarket chains like WalMart, Target and Ahold Delhaize. This really happened and has proven to be a wonderful buying opportunity to me.
So let’s assume in this case that the market will find it’s common sense back again within a year from now. You also believe that Ahold Delhaize would quickly return to at least 30 Euro. At the same time you wouldn’t mind buying an additional 100 shares of Ahold Delhaize at 22 Euro.
In this case and at today’s prices you would be able to sell a put option for 1.23 Euro (123 Euro) with a strike price at 22.00 Euro and an Expiration date of 18 June 2021.
At the same time you can use that money to purchase a Call option for 1.20 Euro (120 Euro) with a strike price at 26 Euro at the same expiration date.
This hypothetical trade would either allow you to purchase 100 additional shares at a ~15% discount from an already undervalued share price. Or you would benefit from the rebound and start making a profit when the stock price would start trading above 26 Euro.
A price next year in between 22 Euro and 26 Euro would mean that you have no gains from this trade.
This is also the reason why I consider this a “zero-cost” trade which is speculating on a rebound.
However, to be clear, it is not truly zero-cost, because the main costs involved are probably a bit less tangible:
- an opportunity cost, because in this case you would also be required to keep a margin (20%). This means that you can’t use that money for the whole year to invest in other income generating opportunities (like dividend paying stocks)
- transaction costs. Although relatively low, they still lower your return on investment
I find this personally a very interesting strategy provided that I’m very much convinced of an irrational market that puts a certain stock at bargain prices.
Having said that, I believe that I have used this option income strategy on average once a year. I did it with Shell back in 2016 at the bottom of the oil crisis, with Ahold Delhaize in September 2017 and Abbvie in August 2019.
All these trades have done me very well. However, currently I’m not aware of any stock in my desired portfolio for which I find this strategy viable. Especially not knowing that I anticipate a wider market correction in Q4 if the US gets a Democratic president (the Trump market premium would be gone).
Last but not least, the risks related to this strategy are in my opinion exactly the same as in the first strategy due to the risks associated to selling a put option.
Final Thoughts & Conclusion
I hope that you found this post interesting.
Just be aware that trading options comes with risk. oftentimes with more risk than buying stocks due to the “hedging”. However if done wisely, it can provide you with additional income lik I’ve shown in my two option income strategies. This income could be reinvested into your portfolio to push your compounding effect to the max 💪
I find my own 2 option income strategies actually pretty conservative. Over the last 5 years I had only two cases in which my options got “called”. Both times I decided to own the shares and I have no regrets at all.
Having said that, I do hope that I was able to explain my two option income strategies in a consumable manner. If this was not the case, then please let me know. Your questions might help me in getting to the right level of simplicity and detail.
I’m writing this post for you, not for myself.
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European Dividend Growth Investor