Selling options contracts is a great strategy. I’ve been doing it successfully for almost 30 years now.
On Wednesday, I laid the foundation for why selling options is better than buying options (except in one case, which you’ll learn about later).
The odds are highly stacked against option buyers because of the types of trades they tend to make. These usually consist of buying short-term, out-of-the-money (OTM) strike prices.
When doing that, it makes it extremely difficult to win.
That type of trade signifies that the investor knows exactly where the stock will be on an exact date (expiration day).
Consider a $50 stock…
Many novice investors think it could rally to $70 within the next two months.
Little do they know, based on the stock’s past trading history, that it has no chance of moving that far in such a short time. But that doesn’t stop the investor from buying the call-option contract to satisfy his speculation.
It’s bets like those that will fail upwards of 90% of the time and keep option sellers like me in business.
(Of course, not everyone falls victim to this “problem.” My colleague, Adam O’Dell, has a very successful option-buying strategy with Cycle 9 Alert. You’ve just got to know what you’re doing.)
So, how can we take advantage of it today?
Selling Covered Call Options
If you’ve ever traded options before, I bet one of your first forays into the game was by using a technique known as “selling covered call options”.
The reason being?
Your broker deemed it simple to explain and an extremely safe way to use options.
For every 100 shares of a stock that you currently own, you could sell one call-option contract that would bring immediate cash into your account. It’s a great method to create an income stream that wasn’t there the day before.
On top of that, the income you receive from selling the call options could act as a partial buffer against any future downside activity occurring in the stock.
It’s called a “covered call” because the 100 shares in your account “covers” the sale of the call option, which technically has an unlimited upside risk feature. The 100 shares of stock prevents that unlimited loss from happening. That’s why brokers deem the strategy super safe.
Let’s take a look at an example using everyone’s (almost!) favorite stock – Apple (Nasdaq: AAPL).
This table shows a sampling of AAPL call options that expire in July 2019.
With AAPL stock currently trading near $160.89, anyone with at least 100 shares of AAPL stock already in their trading account can sell one of the call options listed above and receive the going rate.
For instance, let’s say you purchased 100 shares of AAPL for $100 per share back in early 2016.
You’re currently sitting on a $60 per share gain (60%), but would like to create a little cash flow and gain a bit of downside protection.
You could choose to sell the July 2019 $200 strike call option for $3.85 per contract (splitting the bid/ask) and immediately receive $385 into your account.
Since each option contract is equivalent to 100 shares of stock, you would multiply the option price of $3.85 by the 100-share multiplier, equaling the payout of $385.
Why choose the $200 strike?
The strike price represents the level of the stock where you would potentially transact the shares at the July 2019 expiration.
In this case, since you are the call-option seller, you would have to give up (sell) your shares to the call option buyer if AAPL stock trades above $200 by July 2019.
In exchange for that obligation, you received the $385.
What Happens in July?
Two scenarios can occur in July:
1. AAPL stock remains below $200 per share.
If this is the case, the call options would expire with no value and you keep the $385. The obligation to sell the shares at $200 per will cease to exist.
You could then sell another round of call options, collect another round of cash, and wait until the next expiration period to see what happens.
Wash, rinse, repeat.
2. AAPL stock closes above $200 in July.
If this is the case, you will give up your shares to the call option buyer at $200 a pop and your position will disappear from your account.
You still get to keep the $385, and book a realized gain of $100 per share from your original investment.
A 100% return!
Items to Note
1. You can choose any strike price or expiration period you desire.
The longer the expiration, the more money each option will pay out.
The higher the strike price, the less money you will receive.
Choose a combination that meets your financial goals.
2. Ideally you should pick a strike price that you would be OK with if you had to give up your shares, because, if the stock keeps rising, you will miss out on future upside gains.
If you think AAPL may go blasting higher and don’t want to potentially sell the shares at $200 each, then pick a higher strike price, like the $210 or $220.
3. You can bail out of the trade at any time if you wish.
Don’t feel comfortable in the trade anymore? No problem. Just buy the call options back at the going rate and the trade will be done.
If you choose this route, you may incur a profit or loss on the transaction, depending on the price of the call option at that time.
The bottom-line here is that using options can add an element to your trading toolbox that you never knew existed.
Having long shares of stock in your account can be a great source to add extra income that wasn’t there the day before.
In many cases, if you choose a strike price that is very far away from the current price of the stock, chances are it will expire worthless as the stock won’t reach the strike price by expiration.
For another look at selling covered calls, click here for one of my previous discussions.
Come back next Wednesday and I’ll reveal the second option-selling strategy.