In today’s low interest rate environment, investment grade bonds may not necessarily present the best solution for income investors. And while default rates on high-yield bonds continue to run in a fairly negligible range, it may not be a prudent idea to load up on them. Thus, those seeking elevated and diversified income streams continue to tap equity markets and alternative investments for pieces of their overall income puzzle.
While most are familiar with the dividend yields produced by traditional C-corp. dividend paying stocks like your General Electrics, Microsofts, and Pfizers – few tend to be acquainted with the income generating capabilities of the options market. Options provide flexibility for the average investor and can be a way to hedge risk, expose oneself to equity markets with minimal initial capital allocation, and, yes, generate additional income for a portfolio.
For purposes of this article, we will discuss covered call selling and cash secured put selling – two of the most basic, and safest, option selling strategies for generating extra portfolio income. We will utilize current options pricing on General Electric as a discussion point. While I do own GE in my personal portfolio, I do not currently have options exposure to the stock.
Covered Call Selling
Just like in an equity transaction, an options trade has both a buyer and a seller. The buyer of a “call” option on GE thinks that the price will go up over a defined span of time, while the call seller generally thinks the price will remain flat over the same time period. The buyer pays what is called a “premium” for the right, but not the obligation, to purchase GE during a defined time at a defined price. The seller of a covered call, someone who actually owns shares of GE, pockets that premium off the bat as compensation for providing the buyer that flexibility.
So using current quote information, let’s say that our buyer believes that by September 20 of this year, GE will be much higher than $28 a share (currently about $26.50). Our buyer commits to buying 10 contracts or 1000 underlying shares of GE (1 contract = 100 shares) with a call price (otherwise known as strike price) of $28. The buyer is willing to pay 25 cents per share, $25 per contract, or $250 gross (without commissions) for the right to buy GE at $28 anytime between now and September 20, 2014. The covered call seller who takes the other side of that trade, owns at least 1000 shares of GE and warrantees to sell those shares to the buyer at a price of $28 on or before September 20, 2014.
Whether the buyer exercises the option or not, the covered call seller receives $250 right away. If GE’s stock takes off and trades above $30 by September 20, the buyer in all likelihood exercises this option and the seller must relinquish control of the shares with compensation of only $28 a share minus commissions. If GE’s stock stays below or right around $28, in all likelihood the option expires worthless, so the covered call seller keeps the premium, which is almost 1% of the underlying holding, and holds onto their 1000 shares of GE stock as well.
Cash Secured Put Selling
In a put transaction, as opposed to a call, the “buyer” is actually purchasing the right to sell a stock at a certain price. In a simple put transaction, the buyer may own the stock and is looking to save a gain or potentially protect against further loss. In any case, the seller of the put is providing the “insurance” to the buyer for a premium.
Let’s say that an owner of 1000 shares of GE is concerned, but not positive, that the market may tank over the summer. Since selling right away might generate a large capital gain, they choose instead to buy 10 – September 20 put contracts about 10% below market, at a $24 strike, for 25 cents a share. So this time, for $250, the put buyer is paying the put seller for the right, but not the obligation, to sell 10 contracts of GE.
The seller of a put contract may not own shares of GE but should have $24,000 of cash available to buy the shares if the option is exercised at $24 a share. Put selling is a good way of raising cash, but, in addition, is a potential method of coming to own a stock one likes at below current market prices. If you like GE, but don’t want to pay $26.50, you can sell the puts, earn premium, and potentially own shares at better prices.
Writing, or selling, options is not a risk-free activity. Stock gaps or swift market moves can minimize or eliminate potential gains and can lead to tremendous loss. In general, the writing of options as an income strategy works best in fairly flat markets, although more premium can be gained in volatile markets. Thoroughly understand the basics behind options before engaging in any call or put selling.
Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.
About the author:
Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.