Why do I sell put options and covered calls when I am a dividend growth investor? The answer is simple. I want income.
When I was looking for a strategy about a year ago after I nearly destroyed my account, I asked myself a question: “what do you want from your investment? What your account should accomplish?”
Of course, there are a plenty of answers, such as enough money for retirement, growth, hit the home run, income, value, etc.
I wanted income. Some people say that you want income when you are already retired, before you should strive for growth. And if possible aggressive growth.
But recessions, corrections and high volatility in the past convinced me that once I receive the income, it is mine. No one can take it from you. You can spend it, lose it, or reinvest it. I wanted income which I can add to my contributions and reinvest even more money.
Income source #1 – dividends
What stocks can bring you income? Cash on hand which you can withdraw anytime you want? Of course it is dividend paying stocks which can do that for you. So I decided to start buying high quality stocks, which pay dividends, have sustainable dividend growth and great dividend history.
But when I received my first dividend it was only 12 or 20 dollars per quarter. My small account couldn’t generate more cash. What can you do then?
Income source #2 – options
My next choice was trading options. Previously I had a great experience with options so I knew what options could do for any investor, not just me. But from my previous trading I also knew that it would not be any advanced option trading I wanted. I still didn’t want the “prediction” part in trading advanced options.
So what trading would be the best? Simple basic options strategies such as naked puts or covered calls.
Why selling options? When you sell options, you receive cash on hand right away. Nobody can take it away from you. These type of options are called credit trades, because you receive cash – credit.
This credit is an additional income I can put on top of my dividends, spend it, lose it, or reinvest it. And no one can take it away.
Since March 2013 I made $1919.74 in options trading of additional income. That equals to 38.39% gain or 108.31% annualized profit. I could take that money and reinvest.
Do you remember what my goal is? My goal is to pay off the debt first. So I suspended any cash contributions to my account. All growth and new investments are made only from profits made in dividends and selling options.
How you can sell put options? Here are some important steps.
Step #1 – sell put options only against stocks you are OK to buy
When I was learning how to sell puts, I had problem with this rule. I didn’t want to be assigned to the stock ownership because I didn’t want the stock.
It was crucial for me to realize that I have to sell options only against stocks I would normally buy. Stocks I want to own. If the trade goes against you, the worst case scenario will actually be your best one – you will buy 100 shares of a stock you like and you want. This gives you a great peace of mind!
Example: I like many stocks I want to own, but I chose Safeway as the stock for my put selling. I will be selling puts as long as I can or have enough money. And if the worst happen I will be forced to buy 100 shares of this stock. Will that be a tragedy? Of course not!
Step #2 – select safe strike price
To chose the correct strike price for your option you would need to be in tune with the stock, have knowledge of technical analysis and partially a fundamental analysis too.
Let’s take a look at the example. I looked at SWY chart to see where the potential support for the stock price could be.
At the chart I can see two potential supports, one at $32 a share and the second at $30 a share. To select the proper support will be determined by the time of your option and the credit you can receive. So let’s take a look at the option chain to see what options are available around these levels.
Step #3 – select your expiration time
Open an options chain in your brokerage account to see what strikes and what prices are available:
I want monthly income from my trades as I do not want to be waiting 5 months for expiration. If I select monthly income and will be able to collect 0.40 (or $40) dollars monthly, in 5 months I can collect $200 dollars. If you take a look at March 22 2014 put option I will only be able to collect 1.70 (or $170) for the same period and I am taking larger risk hoping the stock will remain above $31 strike in 5 months.
So I decided to check the November 16, 2013 options chain.
Then take a look at the Puts table and since we will be selling puts our corresponding column is called Bid.
When I was selling this put option the stock was above #33 a share. Today, when writing this report the stock is below $33 a share. Thus $33 strike is already In-the-money.
Do you remember what supports I was looking at? It was either $30 a share or $32 a share. Yesterday the 32 strike was out-of the-money while today it is at-the-money. Since the 30 strike offers only $10 for the contract, this trade doesn’t make sense. The 31 strike offers $25 per contract which can be considerable, but 32 strike offers 50 dollars per contract (yesterday when I was opening the trade it was 40 dollars.
I chose to open November 16, 2013 32 strike put.
Step #4 – have your plan in place before opening the trade
This is a very important step! The previous steps were just technicalities, but this step is the heart of your trade. Without it you end up blind and paralyzed to act when the trade turns against you.
Before you open a trade you must ask and answer the question – what everything can happen with my trade and what I can do to fix it?
So what are the outcomes of this trade? There are only three possible outcomes, but several possible steps to take to react properly.
- The stock will end above the 32 strike at expiration – November 16, 2013
- The stock will end below the 32 strike at expiration – November 16, 2013
- You will get an early exercise
The stock ends up above 32 at expiration
This is the best outcome in this trade. If that happens the option expires worthless. It will be removed from your account, your maintenance deposit will be released, you keep your credit and you can repeat the trade.
The stock ends below 32 at expiration
If this happens you have the following options:
- Roll the trade further in time and lower strike
- Close it and take the loss
- Let the option be exercised and buy 100 shares at $32 a share
I would opt for rolling the option farther in time and lower strike. For example, if the stock falls down to $30 a share I will buy my option back and sell January or March 2014 30 strike put option. This transaction will most likely be a wash. That means that I will use the credit received to buy back the in the money option. So this trade will cost me nothing.
If however rolling the option in time and strike won’t help, I may decide to take a loss and close the contract by buying it back. But that is not an option for me as I would do whatever it takes to fix the trade and get out either break even or with a small gain.
The third option is to get exercised. And here comes my advice #1 from above – sell puts only against stocks you are OK to own. If this happens you will be forced to purchase 100 shares of Safeway at 32 dollars a share no matter where the stock price is.
But this isn’t as bad as it looks. From the strike of 32 dollars you have to subtract the premium we received before. In my trade example it was 0.40 per contract. Thus my cost basis will actually be $31.60 (break even) per share and not $32.
Since I already collected several premiums from my previously sold put contracts, my cost basis would actually be as follows:
- $2.20 premium collected in March
- $0.35 premium collected in September
- $0.40 premium collected in October
+ $32.00 strike – stock purchase price
= 29.05 break even – actual cost basis
As you can see, if I get exercised, I will be purchasing at $32 a share, but my actual cost basis will be $29.05 a share. Will the stock drop that deep? Of course it may happen, but if no turbulence, panic or company disaster shows up, the stock shouldn’t experience such a deep drop and even if I get exercised I will own the stock still relatively cheap.
Hope this step by step process on selling a put option against a stock and collect additional income was helpful. If you still have questions or need help do not hesitate to ask. I will gladly help you with your own trade.