Selling Options

Selling Options - Older Information

NOTE: If you have read my most recent post I am shelving Option selling for the time being. It performed very well over the past year however I'm trying to get a little more out with a new strategy. Still this is good information to have so read up and let me know if you have questions.

Risk: Medium to High
Return: Medium to High
Allocation: 30%

     Soon after begining my investment portfolio I read a very interesting article about trading Options. For those of you who don't know, a Stock Option is an agreement to buy or sell a particular stock at a particular price. At the time the my portfolio was performing just fine but I was looking for a slightly more active investing strategy that I still considered to be relativley safe. This really is worth getting to know and quite simple once you grasp the concept. There is a lot of information in this post but bear with me and read through it. A slight caveat, I may not have all of these terms correct depending on who you talk to or which sites you read however the information is correct and will teach you what you need to know to buy or sell Options.

    Most people who have heard of Options have usually only heard about Buying Options. This is basically placing a bet against a stock called a Call or a Put. We are actually more interested in Selling these which means we are getting paid to make the agreement.

Important Terms

Here are some terms you should learn before we start talking about Options:

Put: an agreement to buy a stock.

Call: an agreement to sell a stock.

Contract: standard unit of trading in options, equal to 100 shares of the underlying stock.

Strike Price: the underlying stock price that is set in the agreement.

Expiration Date: the date that dictates whether an Option is exercised or expires

     Lets step back and look at these terms. Options follow a set of specific rules. All options have an Expiration Date. That is the date that the option is either acted on or ceases to exist. Options usually last until this date before being exercised. Most stocks that have Options traded on them do so in as little as 30 day increments, some all the way up to 5 years. Much like a stock, the price of an Option is set by the market and available on most stock market websites. The price of the underlying stock in the Option is called the Strike Price. The price of that stock determines what happens to the Option. All Options are traded in bundles of 100 shares of the underlying stock called a Contract.

So each Option is a Put or Call of a number of Contracts at a specific Strike Price with a specific Expiration Date.

Selling vs. Buying

     In my portfolio I am selling Puts and Calls instead of buying them and here is why. The difference between selling and buying is very simple. When you sell a put or call the payment that you receive is the return on the investment. Typically this isn't a large amount of money for the stocks that I am using for the purpose, usually somewhere around 1% per month is what I shoot for. The key here is that the market can do nothing and I still take home that 1%. So out of the 3 things the market can do (up, down, stay) I keep my money on 2 out of 3 of them. Even if the third outcome happens I'm not really phased and I'll explain why later. This makes the investment practically bullet proof given a length of time.

     On the other hand if you buy an Option you need the underlying stock to move in a specific direction. If it does not then your Option expires and the money you have spent is lost. The advantage to buying options lies in the fact that if you bet correctly your return will be as high as the underlying stock moves in the correct direction vs the locked in profit of selling an Option. You could stand to make much more than 1% if you are correct. More often however you lose that fee and see nothing in return. Being the conservative investor that I am I'd rather bet on lower profit and higher chances than hitting it big with how touchy the market can be.

How to Begin Selling Options

    The first thing you need to do when considering Options is to have your broker approve you for Options trading. This is usually a second form that you can fill out at any time and submit to your broker. Some brokers require a minimum account balance before you will be approved to sell Options. Beyond that some brokers require all of your Options to be cash secured unless you have a higher account balance. All that means is that you have the money ready in case you have to actually have to buy or sell a stock. We are going to be doing this anyway as it is the safest way to sell Options. Check with your broker and make sure you are approved to both buy and sell Options. Brokers will let almost anyone buy an option, selling is the red velvet rope you need to get behind.

     Once approved you need to choose a stock. Not all stocks support Options trading so be aware that you may not be able to trade Options on your favorite stock. A good place to check is Google Finance. Search for a stock that you like and find "Options Chain" on the left hand navigation menu. This will show you the available options for that stock, if any.

     Lastly we are working on Cash Secured Options. What this means is that you need to have the money available to buy the stock you are selling Options on in the account. Remember that each Contract is worth 100 shares of the underlying stock so make sure you have enough to fund at least 100 shares of your chosen stock. Personally I place my Options on Blue Chip Dividend stock which I will be writing a post about later but for now I've been working Lowe's [LOW] for a year now and it has been doing well.

Selling Your First Put

     My advice for your first Option trade is to sell a Put. In this configuration you are being paid a fee to enter into an agreement to buy a certain number of stock should the price of that stock drop to a certain price before a certain date. Its a lot of jargon to wrap your head around but here is an easy to follow example:

Stock X is at $10 a share.
You sell a Put on Stock X at an $8 Strike Price for 2 Contracts at $0.07 a share with an Expiration of next Friday.
You must have $1600 in your account to cash secure the option (2 contracts= 200 shares x $8 a share).
The market pays you the fee ($0.07 per share) coming to $14 for making the agreement.

Fast forward to next Friday which is the expiration date for the Option. The only thing you are worried about here is the current price of the stock and your Strike Price. If the stock is above the Strike Price by even one cent your option will expire and nothing happens. You keep the $14 you made off the agreement (and your $1600 cash secure in your account is "free" for more trading) and walk away. That's it.

If however the stock price is below the Strike Price you will buy the stock at the Strike Price. This means that if stock X drops to $7 a share you will still be required to buy it at $8 a share. While this would be a $400 immediate "loss" of value, this is why it is important to pick your stock carefully. This type of move can happen but if your underlying stock is strong you can expect it to eventually come back. And when it does you can leverage it with Calls to make even more off of it. I'll be writing an article about Calls soon.

Here is a real world example from January this year.

The current price of Walgreens [WAG] is $40.01. We are looking for an Option that expires in 30 days or less and there is only one choice available that expires on Feb 15. We are going to Sell the Put for a strike price just underneath of the current value of the stock. The fee on a Put for the $40 Strike Price is currently $0.70. So we will sell one contract for WAG at $40. Remember that you have to sell Options in 100 share bundles called contracts so we are only going to sell one contract for the example. We will need $4000 ($40 x 100) of cash in our account to secure this Option. We will also need the $5 fee to pay the broker for the trade. Once we have the $4005 dollars in the account then we will Sell a Put for WAG with one contract at $40 with an expiration of Feb 15 2013. The market will pay our account $70 ($0.70 x100) immediatley and then we have to wait. If the WAG stock drops below $40 our broker will take out the $4000 and buy 100 shares of WAG that get placed in our account. If the price of WAG stays the same or goes higher then on Feb 15 the option will expire and we keep our $4000 with the fee of $70 and find another Put to sell.

Risk - You may end up having to buy stock at a higher price point then what the stock is worth on the market. However, because we are only selling on Blue Chip Stocks I don't consider having to hold onto one of these stocks a significant amount of time as that large of a risk. In the worse case scenario I can hold the stock that I purchased indefinatley as part of my dividend stock allocation and raise new funds to begin selling Puts again.

Return - Pay attention to the payout on your puts and you could raise 10% and above in profit. My first 6 months I raised 15% in profits being relativly conservative.

Allocation - I'm at 30% for my options allocation. Once I saw the profit that I was able to create with the saftey of this system I allocated rather heavily. Keep in mind that while this does build wealth we are still focused on an income stream for this portfolio and because of the nature of options trading the payout can vary dramatically so I advise against diving head first into something like 50% allocation.