If you are looking for a way to generate income, why not give options a try?
Strategy: Earn income by selling PUTs OR own good stock at a good value.
By simple definition, a put option is an option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time. (Courtesy of Investopedia).
Rules: For me, premium > 2% of strike price would be safe. (I always aim higher)
- Find a stock. I find my inspiration from the guys who do their homework. (read Warren Buffet, Peter Lynch, etc)
- Look for a stock which you are willing to buy. Best choice is if it is currently undervalued.
- The strike price I choose is always below the current stock price.
- Sell a PUT at a price with a premium which can give you > 2% of strike price. (This gives you a margin of safety)
- Collect premium and wait for the option expiration date.
What just happened?
I sold a contract to buy stock at a certain price (strike price). If the option date reaches maturity, it expires or gets exercised. Expire means that I don’t get the stock and exercised means that I get to buy good stock at a good price. Either way, I keep the premium.
You can keep doing this over and and over again. Take for example:
I sold PUTs of KMI at strike price 17.5 for .55 due on 15 April 2016. (3.14% of strike price).
Options expired and I again sold PUTs of KMI at strike price 17.5 for .57 due on 20 May 2016 2016. (3.25%)
Lets do the math here:
Assuming 3% return every month, in one year, that is a return of 12×3%=36%.
When you sell a PUT, you should reserve money for that PUT (in the event of an option exercise). That’s your “capital”.
36% of that “capital” would be my premium before commissions. And if you compound this every month, i.e, use the premiums to increase the number of PUTs you can sell or use for other PUTs…. you can imagine.
OK, so in this scenario, the sell PUT options were not exercised. The reason was obvious, the price of KMI on 15 April was $18.16. When I sold the PUT, the logical price which the seller would exercise the option was if the price reaches $16.95 and below (taking into account that he paid a premium for my PUT option). At the time of this post, KMI is trading at $19.16, which is $1.66 above my strike price for May 2016.
There are others who claim that they can do more than 200% – 300% in a year. But it probably takes a lot more work and strategies. I am lazy and contented with 36%.
If you do your homework and analysis, options being exercised should happen infrequently. But it could and does happen. And if it does, what can you do? That’s another topic for another time.