Some of you know I have a multi pronged approach to my overall investing.
Long term investing - I buy and hold undervalued stocks for the current precious metals and commodities bull market
65% of my portfolio
Swing Trading - I place shorter term trades based on technical analysis - holding between a couple days to a couple weeks or even months
10% of my portfolio
Options Trading, selling cash covered puts for weekly and monthly income.
25% of my portfolio
Today’s report will focus on #3, selling cash covered puts for income. This is by far my FAVORITE, most reliable, most conservative way of earning money.
But First, A Quick Lesson In Options:
Options can be categorized in two buckets: Calls & Puts
Call Option -
Call option buyers make a cash payment, called a premium, which allows them to buy the underlying stock at a later, specified date and a specified price
When the stock price goes up, the value of your call option also goes up, all else being equal. Call buyers are bullish and believe the underlying stock will go up
Put Option -
Put option buyers also make a cash payment but this allows them to SELL the underlying stock at a later, specified date and specified price.
When the stock price goes down, the put option increases in value. Buy a put when you believe the price will go down
.
Now remember there are always two sides to every transaction, a buyer and a seller (or a Long and Short). I outlined the buy side of options where you PAY because you believe the stock will go up in the case of calls…or down in the case of puts. The other side of that transaction is the one who sells those options…or receives the premium paid. This is where I come in.
I like receiving premium vs paying premium.
Put Selling
The options strategy that allows me to collect premium is called put selling, or put writing. On this side of the trade, I am the one receiving the premium that the option buyer is paying. Remember, the buyer of the put option has the right to SELL the underlying stock, thus giving them limited downside risk. Like insurance. They are paying an ‘insurance premium’ to protect or hedge their downside risk.
“By selling puts, I act similarly to an insurance company. I receive the monthly insurance premium in exchange for covering the put buyer’s cost in the event of a catastrophe, or downside move in the stock.” - - Eric Hyde, just now.
This means that I receive this premium in exchange for the promise to potentially buy those shares if specific parameters are met (specific price by certain date).
One more note: each options contract represents 100 shares.
Enough Talky Talk…Let’s Look at an Example:
Selling CCJ Puts
Since I am a uranium bull longer term, let’s look at one of the largest uranium producers, Cameco, ticker symbol CCJ. Cameco was recently trading at $22.27. If I am BULLISH and believe Cameco will be higher in the future (which I do), I might buy 100 shares today for $2,227. There is nothing wrong with that.
However, as an alternative, I can sell one put option contract with a strike price of $20 that expires January 20th, for example. For selling this contract, I would receive $2.67 per share, or $267 for the entire contract. (Remember each contract represents 100 shares). Options chains are priced on a ‘per share’ basis so multiply the price by 100 to calculate your premium.
There are other strike prices and expiration dates to choose from, but in this example I chose the January expiration and $20 strike price. You can see you’d receive more premium for the $22s, $25s, and $27s, for example.
And if I sell 10 contracts, I receive $2,670. This represents 1000 shares, or a $20,000 outlay IF I get assigned the shares.
In either example, I would immediately receive the premium into my account that is now mine forever. I can withdraw it and take the wife out to dinner (smart man!), leave it in my account as cash, or invest it immediately. It is my money.
Did I mention this is a return of over 13% return for 6 months? …or 26% annualized. Not too shabby.
All Day Long…
So what is my obligation now? After all, I didn’t receive this money for nothing.
By selling this option, I am agreeing to buy 100 shares of CCJ, on or before January 20th, for $20, IF the price is $20 or lower. Otherwise the option expires worthless (that’s good as an options seller).
If I like Cameco now, why not like it 10% cheaper? And oh, yeah, I was paid a $2.67 premium already when selling the put. So my cost basis if I were to be assigned the shares would be $17.33…a 22% discount from current levels!
I’ll take that all day long.
But what happens if CCJ is trading higher than $20 per share on Jan. 20th?
Wouldn’t the owner of those shares rather sell them at the higher price than to me at $20? YES…which means I would not be required to buy them! In that example, the option expires worthless, my obligation is no longer, and I just keep the premium and move on. Rinse. Repeat.
I’ll take that all day long, too!
As you can see in this example, I make money even if the stock drops. If the stock drops by $2 from today’s value of $22.27 to $20.27, for example, I win. If the stock doesn’t move at all in 5 months, I win. If the stock goes up in value, I win. Hell, if the stock fell to $18 and I had to buy it at $20, I STILL make money! Remember, my cost basis is $17.33 after receiving my premium.
Pick a Different Strike Price or Expiration Date
And of course you can go shorter or longer in time as well as choose a different strike price. These variable affect how much you receive in premium. Generally, the higher the premium with a shorter timeframe, the greater likelihood of assignment. Again, maybe that’s what you want.
Here is the put options chain for CCJ. If you chose the Jan. 20th $22 strike price you would receive almost $400 while at the same time running a higher risk of being assigned since CCJ is trading slightly above $22.
Worst Case Scenario
So what’s the catch?
Worst case scenario…I get to buy a stock I wanted to buy anyway. That’s it.
Now of course, if you sell a put then get assigned the shares, those shares could continue dropping in value. This is true of ANY investment, obviously.
Stock Selection
Stock selection is important. I have a few rules I follow:
Most important rule: ONLY SELL PUTS ON COMPANIES YOU ARE COMFORTABLE OWNING.
I start with a sector or industry I like with a good outlook. I favor commodities at this stage in the cycle. Many commodities have recently been deeply oversold due to recession fears. This may continue of course but we are seeing great entry positions.
Companies with market capitalization above $500M on good volume for liquidity
Good balance sheets, little to no debt
Value NOT growth
Sell puts on down days during high volatility - premiums are higher when the volatility is high. This means the options buyer is willing to pay a higher premium (to ME) to hedge their position. And when the underlying stock is DOWN, the option premium you receive will be UP.
If placing multiple trades, I diversify my put selling across various asset classes
Additional Stuff…
I have some other rules I follow but those above are the big ones. I also use certain tools know as “the Greeks” to help me in selecting strike price and expiration date.
The two most useful for me are
Theta, which addresses time decay
Delta, which guides me on probability of being assigned, to put it simply.
Both of these will be addressed on another report.
Occasionally I do get assigned shares because the stocked moved below my strike price. When this happens, I make a decision from there whether to hold longer term or use another options strategy where I sell CALLS against the shares I now own. This is another powerful way to earn monthly income on the new assets you own.
I’ll save that for another report too!
The Bottom Line
The sale of put options can generate additional portfolio income while potentially gaining exposure to securities that you would like to own but at a price below the current market price. This income strategy is a portion of my overall investing strategy.
That’s all for now. Thanks for reading everyone.
Eric
I’d love for you to leave a comment and let me know what you think.
Share the report with a friend. Get the word out.
Ok, so let's see if I understood. I'm watching Disney. I can sell a put on Disney for $85 a share for 100 shares? I think that's a great price, so if I get stuck with it, no biggie, and it might be lower than that to purchase anyway. But if it doesn't get that low, then I keep the $$ I got for selling the put, and no obligation to purchase?
Very good job of explaining Eric...and appreciate your tidbits of humor. :D
One key thing about getting into this strategy is knowing you need to open a brokerage account with at least $25K to be allowed to participate in this strategy.
Aside from that, you're doing great and looking forward to more editions of this report.