At a certain juncture within an investor's learning journey, the three basic types of assets – namely equities, fixed income and cash – reach a limitation in their capacity to generate enough income without compromising safety.
Exploring options as an investment strategy
For more advanced and adventurous investors, equity options present a viable avenue to generate secure income. Equity options are derivatives which derive their value, risk assessment and fundamental term structure from an underlying asset, like a stock, exchange-traded fund or index.
Options function akin to insurance policies, where one party takes on risk in exchange for a premium while the counter party offloads risk while paying a premium. Options, while predominantly engaged with by large institutional investors, an increasing number of individual investors are embracing options within their brokerage accounts. This shift arises as trading platforms evolve in sophistication, and a broader segment of the populace seeks to safeguard their funds against fluctuations in the equity market or to speculate of market movements. Option investing is rapidly growing in popularity driven by younger retail investors as well as the rapid rise of discount brokers who have made trading seamless and affordable.
Buying and selling o ptions
Buying equity options (i.e., taking a long position) grants investors the privilege, though not the obligation, to buy or sell said underlying asset. Selling (also known as writing or taking a short position) an option, on the other hand, obligates the seller to buy or sell the underlying asset. While the very idea of options scare some investors, they do not have to be scary or risky. There are many conservative strategies in the world of options which can be utilized to generate income without taking on a whole lot of risk. Options, in my opinion, are like fire; sure, it is dangerous if it gets out of hand, but if it is controlled, it is very useful.
In this discussion, I will describe two simple options strategies that can be easily used by investors to generate extra income with little additional risk. Both strategies involve "selling" (or writing) options. The options are written at a strike price close to where the stock is currently traded. So these options currently are at or near the money.
Out of the money covered call
A covered call is a popular options trading strategy that involves an investor owning an underlying asset, typically stocks, and simultaneously selling a call option on that asset. This strategy is often used by investors who hold a particular stock and are looking to generate additional income from their holdings while potentially limiting some of the downside risk.
Here's how a covered call works:
- Ownership of underlying asset: The investor already owns a certain amount of a particular stock. This ownership of the stock is what "covers" the call option position.
- Selling a call option: The investor then sells (writes) a call option on the same stock they own. A call option gives the buyer the right, but not the obligation, to purchase the underlying stock at a predetermined price (strike price) before a specified expiration date.
- Generating income: In return for selling the call option, the investor receives a premium (payment) from the buyer of the call option. This premium represents the income generated from the strategy.
If the stock price remains below the strike price of the call option by the expiration date, the call option will expire worthless. The investor keeps the premium received from selling the call, and they can repeat the strategy by selling another call option if desired.
If the stock price rises significantly and is above the strike price at expiration, the buyer of the call option may choose to exercise the option. In this case, the investor's stock will be sold at the strike price, and they still keep the premium received. However, they would miss out on potential gains above the strike price.
The goal of a covered call strategy is to generate income from the premium received while potentially benefiting from small to moderate stock price movements or even slight price decreases. It provides a way to enhance returns and manage risk for investors who are already holding the underlying stock.
It is important to note that while covered calls can provide income and risk reduction, they also have limitations. If the stock price experiences a significant increase, the investor's potential gains are capped at the strike price of the call option. Additionally, if the stock price declines significantly, the premium received from selling the call may not fully offset the losses from the stock's decline.
Example of a covered call
Imagine you own 1,000 shares of Verizon Communications Inc. (VZ, Financial). According to GuruFocus, the company is selling at a depressed price. The company pays a nice dividend of 7.83% and you are underwater on the stock and you do not want to sell it. But you would not mind generating some extra income from your Verizon stock. So you sell (write) some call options on Verizon with a strike price of $34 and an expiry of April 19, 2024. You get a premium of $1.90 for underwriting the risk. Now if the stock is over $34 on April 30, 2024, the stock will be called and you will be forced to sell the stock at $34, but you still get to keep the commission. If the stock remains flat or drops below the strike price, you get to keep the premium. Assuming the stock remains flat, you not only get the annualized dividend of 7.83%, but get the annualized call premium of 8.77%.
Of course the risk is that if the stock rises much above the stock price, you will have lost the opportunity for the gain. You pay for this strategy by losing out on this opportunity. In this case, a forced sell could be painful if the stock shoots up. In that case, if you still wanted to hold the stock, you would have to pay the market price.
Cash-covered puts
A cash-covered put is an options trading strategy that involves selling (writing) a put option while simultaneously setting aside enough cash to cover the potential purchase of the underlying asset if the option is exercised. This strategy is considered a more conservative approach compared to naked puts, as the investor has the funds readily available to fulfill their obligation if the put option is exercised.
Here's how a cash-covered put works:
- Selling a put option: The investor sells a put option on a specific stock or underlying asset. A put option gives the buyer the right, but not the obligation, to sell the underlying asset to the investor at a predetermined price (strike price) before a specified expiration date.
- Setting aside cash: Before selling the put option, the investor ensures that they have enough cash in their trading account to cover the potential purchase of the underlying asset at the strike price. This is where the term "cash-covered" comes from. The amount of cash set aside is equal to the strike price multiplied by the number of shares the put option represents.
- Receiving a premium: When the investor sells the put option, they receive a premium (payment) from the buyer of the put option. This premium represents the income generated from the strategy.
If the stock price remains above the strike price of the put option by the expiration date, the put option will expire worthless. The investor keeps the premium received from selling the put option, and the set-aside cash remains untouched.
If the stock price falls below the strike price and the put option is in-the-money (profitable for the option buyer), the buyer may choose to exercise the option. In this case, the investor is obligated to buy the underlying stock at the strike price, and they use the set-aside cash to purchase the stock.
The primary advantage of a cash-covered put is that the investor has the means to fulfill their obligation if the put option is exercised. This reduces the risk compared to naked puts, where the investor might not have the necessary funds to buy the stock at the strike price.
This strategy is often used by investors who are willing and able to buy the underlying stock at a specific (strike) price and are looking to generate income from the premium received by selling the put option. It is a strategy that combines potential income with a conservative risk management approach. However, it is still important to consider market risks and fluctuations when using any options trading strategy.
Example of a cash-covered put
Again using Verizon Communications as an example, you sell (write) some put options with a strike price of $34 and an expiry of April 19, 2024. You get a premium of $3 for underwriting the risk. If on or after the expiration date the stock is over $34, you get to keep the premium. If the stock trades below $34, the stock can be put (i.e., sold) to you at any time before or at expiration. Given the risk of being put, it is imperative that you have cash handy to be able to absorb the forced buy (hence cash-covered put). But the cash does not need to sit idle - it can be in a money market fund earning interest - which is another 4.5% annualized at current rates. In addition, you are also earning some return on the premium collected as you get the premium paid in advance.
Therefore, selling put options can net you up to 19% annualized income as compared to around 8% if you relied on dividend income alone. The risk of being put the stock (i.e., a forced buy) is acceptable in this case as Verizon is, in my view, undervalued. This strategy will not be suitable if the underlying stock is in overvalued territory. You should be prepared to buy the stock if the stock is put to you. Unlike a naked put, which is very risky, we have the cash to buy the stock. A naked put seller who does not have the cash is indeed playing with fire as he does not have the cash to cover his commitment to purchase.
Conclusion
The strategies described illustrate that options do not have to be scary and that conservative investors can use option strategies to generate income from stocks without taking a lot of risk. The covered call strategy is used to juice the income from a stock you already have which you do not mind letting go off if it is called. It works great for stocks you are considering selling anyway and feel that they are close to fully valued or overvalued. The cash-covered put strategy, on the other hand, is ideal for stocks that are undervalued and you do not mind buying them at the strike price if the stock is put to you.
