Using Covered-Calls and Cash-Secured Puts
Let’s say you have saved up some money to buy shares of stock with, but you are nervous about buying too high. What can you do to feel better about how you enter a stock position? Let’s say you are looking to buy 100 shares of a stock that is currently at $15. Instead of using that $1,500 to buy the shares, you can use that money to sell a contract that would obligate you to buy 100 shares at $14. This is called selling a put option. If you get $30 for selling that contract and you do end up buying 100 shares at $14 then you are $130 better off than if you had just bought the shares directly at $15 immediately.
The risk of a cash-secured put comes from the possibility that the shares that you sold the cash-secured put on will drop far below what you intended. If you intended to buy the shares when it drops to $14 and it goes all the way to zero, then you will be obligated to buy 100 shares of stock that are worth nothing for $14, losing $1,400 in the process. I do not mind this risk because it is the exact same risk as simply holding the stock. Another way things could go wrong is if the stock goes up a lot very quickly. In this case you will not lose money but you will have missed out on a big gain.
If you already have at least 100 shares of a certain stock then the covered-call strategy can be used. Let’s say you have 100 shares which are currently at $15 per share you can sell a contract that would obligate you to sell your 100 shares at $16 per share. This is called selling a call option. If you sell this contract for $20 and you do end up selling your shares at $16 per share, then you are ahead $120 as opposed to if you had simply sold your shares directly at $15 per share.
When I talk to people who know nothing about investing they will say “all I know about that is to buy low and sell high.” Selling put options if you have cash, and selling call options if you have stock is the closest thing you will get to a guarantee that you will buy low and sell high. This is because you are getting paid to be patient since you make money every time you sell an option contract. In the example of the $15 stock I would sell a put at $14 and if the stock goes below $14 on the day the put option expires then I would be able to sell a call option at a higher price. This is because I would then have the stock instead of the money. If the put expires without the stock ever going low enough then I would just sell another put until it does. Switching between selling put options and call options is a good strategy for generating income as long as the stock is fundamentally strong enough for you to want in your portfolio anyway.