How to get started selling options.
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One of the most common questions I get here at the Raptor is about how to get started earning income with options trading if you have never traded options before. This is not surprising. Once a month or so, I will detail a trade I have made with an eye popping expected annualized return greater than 50%. That gets people excited. And before I get into the introductory mechanics I want to dispel a myth. Selling options for income is not a guaranteed way to earn returns more than twice of those made by Peter Lynch. In fact, my long term average for options trades comes in a little under 12%. Better than the long term average of the S&P but not something that is going to make me an instant billionaire.
If you are going to trade options for the first time, you need to start by applying for permission at your broker. Since this is an introductory primer, I am going to recommend applying for “level one” access. This gives you access to the simplest and lowest risk forms of option trading: “covered calls” and “cash secured puts”. For simplicity and to ensure my readers are starting out only with the lowest risk approach possible, I will limit discussion to covered calls.
A call is a contract that gives the call holder the right, but not the obligation to buy 100 shares of the underlying stock at a predetermined price (the “strike”) for the duration of the contract (the “expiry”). You will be selling the contract and becoming the contract holder’s “counter-party”. Your shares can thus be “called away” anytime they are “in the money” (above the strike price). You’ll need to own 100 shares of the underlying stock BEFORE selling (or “writing”) said contract. Don’t worry about making an error. With level one options permissions, your broker will cancel the trade before it becomes active if you are not eligible.
Terminology varies by broker but once you have your 100 shares, you will enter an order to “SELL” or sometimes “SELL TO OPEN” a contract. You will select the expiration date (the “expiry”) and the “strike” (the agreed upon price at which you will surrender your shares). You also want to ALWAYS use a “limit order” rather than a “market order” as bid/ask spreads are much wider than with equity or index funds. You can hold the contract till expiry or “BUY” it back (sometimes “BUY TO CLOSE”). Win, lose or draw, you will keep the cash payment (the “premium”) and it is yours to spend or invest.
The benefit of doing this is you earn instant cash income. You basically get to create your own special dividend. This lowers your risk because you take some profit while regular stock holders without a covered call receive no additional income. The downside is you give up potential gains if the underlying stock takes off and exceeds the strike price by expiry. A special note about dividends: sometimes the contract holder will exercise their option and call away your shares even though the stock is below the strike price to capture the dividend just before the ex-dividend date.
I want to give a couple examples so you can see what these trades look like. I’ll go with Microsoft (MSFT) and the Communications Services Spider (XLC).
At the time of writing, MSFT is trading for $104.95. Buying 100 shares would result in a $10,495 cash outlay. You could then sell one contract at the 105 strike, a call with the 21 DEC 2018 expiry, just as an example. The bid/ask spread on this contract is 3.30 to 3.40 with a most recent fill at 3.35 (see screen shot below). That is you will be paid 3.35 PER SHARE (100 shares per contract) to open this contract. For sake of illustration, I’ll use 3.35 as our price. Using today’s date of 26 NOV 2018, the trade would be in force for 26 days. A $335 payment earned against a cost basis of $10,495 comes to an “instant” return of 3.19%. This annualized to 44.81%. Remember that until the contract expires, you have an outstanding liability to sell your shares $105. This is a fantastic return and reflects an expectation in the market that MSFT is likely to move by a “large” amount during the duration of the contract.
At the time of writing, XLC is trading at $43.55. Buying 100 shares would result in a $4,355 cash outlay. You could then sell one contract at the 44 strike, a call with the 21 DEC 2018 expiry. The bid/ask spread on this contract is 1.05 to 1.25 with a most recent fill of 1.30 (see screen shot below). To be conservative, we’ll assume we can get filled at 1.10 PER SHARE. Again, using today’s date of 26 NOV 2018, the trade would be in force for 26 days. A $110 payment earned against a cost basis of $4,355 yields instant income of 2.53%. Annualiz ing this payment to 365 days results in an annualized yield of 35.46%. That is another great return. Candidly, returns are not always this good. Recent volatility in the markets has made options premiums plump making it a great time to be an options seller.
In either case, whether your shares are called away or you get to keep your shares after expiry because the underlying stock closed below the strike, you get to keep 100% of the earned premium. If the stock is called away, you receive a cash payment for your shares times the strike price. In the examples above, this results in a small short term capital gain. If the stock finishes below the strike, you keep your shares and can either sell, hold, or even write another covered call for even more income.
I use this and similar strategies in early retirement and have done so for over six years. Even though I carry a 40% allocation to fixed income, I am able to consistently withdraw 9-10% a year while still growing my asset base. The strategy both produces income and lowers risk. And it historically performs well in bear markets. The reason for this is that in addition to lowering your risk by extracting cash payments, options premiums tend to grow large with volatility, as people will pay more for insurance during a bear market.
I hope this answers some questions and gives you a new tool for investing and early retirement. I am always available to answer questions (but not provide individualized investment advice – that requires a license) at financial [dot] velociraptor [at] gmail [dot] com.
Devour your prey raptors!