Easy Income Starts With These Options Strategies

My topic for today’s Big Interview is options. Now I know what some of you are thinking: options are too complex and they’re too risky.

But as my colleague Jim Fink makes clear below, options can serve as simple, easy ways to generate steady income — especially when a seasoned pro like Jim walks you through it.

And there’s no better teacher than Jim (pictured here).

Jim Fink is chief investment strategist of Options for Income and Velocity Trader. He holds a bachelor’s degree from Yale University, a master’s degree from Harvard’s Kennedy School of Government, a law degree from Columbia University, and an MBA from the University of Virginia’s Darden School of Business.

Jim also has been a member of the Illinois and D.C. bars and is a CFA charterholder.

I asked Jim a few options questions that are specific to income investors. I think you’ll find his answers quite extensive and informative, even for those who don’t want to use options in their investment strategy.

Let’s start the options-for-income conversation.

Income-seekers need to buy and hold broadly diversified, balanced portfolios of yield-paying securities. Their primary concern is that the underlying companies paying the dividends and interest are healthy and growing.

As an advisor, my primary focus is always on the underlying health of the companies whose stocks I recommend. Can you explain to primarily conservative, income-oriented buy-and-holders why using options can help their approach to the market?

Options are wonderful and flexible tools that can be used by stock investors to reduce risk and enhance returns. I think they’ve gotten a bad rap over the years because they’ve been used improperly by “get rich quick” traders rather than long-term investors. As with any tool, options can be abused. But the problem is not with the options tool itself, but in its application.

And I’m here to explain how options can be used in a conservative and income-producing manner that is investor-friendly and perfectly in-line with the investment philosophy of your subscribers.

Stock options are derivatives — they derive their value from the underlying value of a stock. They represent the right to buy or sell 100 shares of that underlying stock at a certain price on or before a predetermined date. There are two types of options, calls and puts.

There are two sides to every option transaction: the party buying the option, who has a long position, and the party selling (also called “writing”) the option, who has a short position. Each side comes with its own risk-reward profile and its own strategies.

 

Call

Put

Buyer (Long)

Right to buy stock

Right to sell stock

Seller (Short)

Obligation to sell stock

Obligation to buy stock

A call is the option to buy the underlying stock at a predetermined price (strike price) by a predetermined date (expiration, which is usually the third Friday of a month). The expiration date chosen can be as soon as next month or as distant as two and a half years away from now. If the call buyer decides to exercise the call option, the call writer is obliged to sell his shares to the call buyer at the strike price.

A put, in contrast, is the option to sell the underlying stock at a predetermined strike price until the expiration date. If the put buyer decides to exercise the put option, the put writer is obliged to buy the stock from the put buyer at the strike price.

A call buyer seeks to make a profit when the price of the underlying shares rises. The call option’s price will normally rise as the shares do, because the right to buy stock at a constant strike price becomes more valuable if the stock is priced higher. Similarly, a put buyer profits when the underlying stock price falls. A put increases in value as the underlying stock decreases in value, because the right to sell stock at a constant strike price becomes more valuable if the stock is priced lower.

Buying options can be risky because they have a limited lifespan. If the stock doesn’t move in the anticipated direction by the expiration date, the option will lose money. The amount of loss depends on the relation of the option’s strike price to the underlying stock price, but the loss could potentially equal the entire amount of one’s initial investment. The reverse is true, too. Options are leveraged investments, so the potential percentage gain from buying an option is much larger than from buying a stock.

One option contract costs much less than 100 shares of stock (which explains option leverage), so a common way to reduce the risk of buying options is to invest much less money into an options positions than a stock position. After all, a 100% loss on an option position that costs only 10% as much as a stock purchase is the same as losing only 10% on a stock position.

But for conservative investors, I don’t recommend purchasing options. Rather, I recommend selling options to complement — not replace — their buy-and-hold stock portfolio. All of the risks associated with buying options are eliminated, and reversed, for the option seller. Option sellers actually benefit if the option expires worthless. They get paid up front in cash and earn extra income. This extra income actually reduces the risk of stock ownership. Imagine that: Options can actually reduce risk.

Part of my overall investment strategy includes paring back on stocks that have risen substantially and buying stocks at cheap prices during fear-induced general market selloffs. How can options facilitate this strategy?

Using options can achieve both of these investment objectives at no additional risk, while generating additional cash income at the same time.

For paring back on overvalued stock positions, I recommend selling covered calls. The term “covered” means that you only sell the number of calls that equal the number of shares of stock you already own (divided by 100, since each call option consists of 100 shares of stock).

Let’s say that you would want to sell 200 shares of your stock holdings at $50 per share. Rather than place a limit order to sell at $50, you could sell two call options with a strike price of $50 for hypothetically $2 per share. If the stock closes above $50 at expiration, the call options would be exercised by the call buyer and you would be required to sell 200 shares of stock at the $50 strike price.

The benefit of selling your stock through option exercise rather than a limit sell order is that you get paid an additional $2 per share in income on top of the $50 sale price, making your net sales price $52.

For buying stock cheap during fear-induced market selloffs, I recommend selling puts. For example, let’s say you’d love to buy a stock if it fell in price to $30. Rather than place a limit order to buy 200 shares at $30, you could sell two put options with a strike price of $30 for, hypothetically, $2 per share. If the stock closes below $30 at expiration, the put option would be exercised by the put buyer and you’d be required to buy 200 shares of stock at the $30 strike price.

The benefit of buying your stock through option exercise rather than a limit buy order is that you get paid an additional $2 per share in income, making your net purchase price only $28.

The great thing about these two option-selling strategies is that you can rest easy without worrying about options expiring worthless. You aren’t speculating on stock movement within a limited time period. Regardless of how the underlying stock price moves, selling options reduces the cost and downside risk of your stock ownership.

The only risk — if you can call it that — is you will make less money than straight stock ownership if the stock price skyrockets upward. But missing out on a speculative upside gain is much less painful than losing money.

To many conservative investors, who are more concerned with capital preservation and income, these two options strategies are comforting.

Many if not most brokerages place restrictions on which of their clients can buy and sell options. Can you talk briefly about what those are?

Merely opening a stock brokerage account will typically not authorize you to trade options. Most brokers require investors to fill out an options trading authorization form, where the investor’s risk tolerance and experience are evaluated. Based on the investor’s answers, the brokerage will typically assign the investor to one of several different option trading levels.

For example, level 1 might permit covered calls only; level 2 might allow level 1 trades plus purchasing options and selling 100% cash-secured puts; level 3 might allow level 2 trades plus selling options as part of a “spread” (i.e., long and short options combined); level 4 might allow selling “naked” equity puts (i.e., short options not covered by long stock, long options, or 100% cash collateral); and level 5 might include everything, including selling “naked” index options.

Regardless of your options trading level, federal regulations don’t permit the use of margin in retirement accounts. Consequently, no IRA investor can short stock, sell naked call options, or sell more put options than they can convert into stock with cash on hand (i.e., only “cash secured” puts are permitted). Many brokers, however, do allow defined-risk spread trading in IRAs, which is a very “limited” form of margin.

Where would you draw the line regarding sophistication or portfolio size for investors you would be comfortable advising to buy and sell options? Is this a safe and realistic strategy for a widow with a very small tolerance for losses? What about an investor who has only bought mutual funds?

For widows and other conservative investors, I would limit option trading to covered calls and selling cash-secured puts. These two options strategies reduce the risk of stock ownership. Remember, however, that the minimum unit of option trading is one contract, which equates to 100 shares of stock. If your account size is so small that your individual stock positions are less than 100 shares, then option trading isn’t possible.

Selling puts should be limited to the number of shares of stock you’d normally be willing to purchase. Diversification theory teaches that no individual stock position should equal more than about 5% of the total value of your equity portfolio.

Consequently, if a stock you wanted to buy trades for $20 per share and your account size is only $10,000, selling one put wouldn’t be wise (even though it was cash secured) because if it were assigned, you’d be required to purchase $2,000 worth of the stock, which would equal a much-too-high allocation to a single stock of 20% of your equity portfolio.

There are no options on traditional mutual funds, but there are options on many of the most popular exchange-traded funds (ETFs). Selling covered calls and selling cash-secured puts makes sense even for conservative ETF investors subject to the limitations described above.

Editor’s Note: I’ve just asked Jim about simple options strategies with which you can create a steady stream of income. But Jim has devised a trading system that scores even bigger gains, in a fraction of the time.

Now Jim wants to share how his proprietary system works… at the Ultimate Profits Summit.

This free online event airs on May 9 at 1:00 p.m. For those who sign up, Jim will reveal how his new system pinpoints four types of trades that could hand you gains of 114%, 211%, 246% and 433%. Sometimes in as little as 36 hours. Spaces are limited; act now. Click here to reserve your spot.

John Persinos is the managing editor of Investing Daily.