Our Top Expert Answers Some Of The Most Common Questions About Selling Options
Back in March, I talked about how billionaire investors like Warren Buffett use simple options strategies to generate millions in extra income.
Yes, you read that right. The man who once famously called derivatives “weapons of mass financial destruction” has used options before.
But before you accuse the Oracle of Omaha of talking out of both sides of his mouth, it’s important to consider how he used them. If you read that piece, then you know he sold put options — one of the safest options income-generating strategies out there, if done properly.
Now, I’m not saying you’ll make millions using this strategy like Buffett. But you can generate thousands of extra income with it each year… Quite easily, in fact, and with very little risk.
For more on options trading and income, I’m turning to Amber Hestla, options strategist over at Income Trader.
I referenced Buffett’s use of options with Coca-Cola (NYSE: KO). What was he trying to do with this strategy?
Amber: Buffett seems to want two things in life — high levels of cash flow and value-priced stocks. He did the math on KO and saw that it was close to a price he was willing to pay. But not quite there.
Most investors will go ahead and buy when price are “close enough” to what they want to pay. But, then again, most people don’t get the kind of results Buffett does. He never loses his head in the market, and Buffett has written in his annual letters that he never pays even a penny more than he thinks a stock is worth.
Selling puts lets you set the exact price that you will pay, as you noted in the Coca-Cola example.
Selling puts also generates income. I target 1% or 2% a month as the minimum on my trades, although I often find trades that deliver two or three times as much income. Sometimes a lot more.
Even with billions of dollars at his disposal, Buffett probably has more ideas than money at times. In this example, Buffett generated $7.5 million in income by selling puts and was able to put that amount into other investments. Knowing his track record, that money could be worth more than $100 million by now since his average gains are nearly 20% a year.
Selling puts allows us to pocket income now and use that for other ideas that are “ready to go” immediately. It helps us avoid overpaying for stocks we want to buy while increasing current income.
When I tell investors that options don’t have to be “risky”, I usually get some pushback. How can investors reduce the risks associated with selling options?
Amber: The best way to reduce risk is to only sell puts on solid companies you would want to own. If you follow this one rule, you’re ahead of 99% of options traders.
When you sell a put on a solid performer, you’re basically betting that a great company won’t fall to fire-sale prices in a short period of time. You receive instant income (known as a premium) from the buyer of the option in return. If the shares remain above what you determine is your dirt-cheap level, you’ll keep the premium as 100% profit and never buy one share.
Once in a while, however, you may have to buy the shares. But that’s not necessarily a bad thing. After all, you’ll be getting a great deal on a stock you’d want to own anyway. The premium you received when you sold the put lowers your cost basis even further. Plus, as you get more comfortable with options, you can then turn around and collect even more income from the stock using a different options strategy: covered calls.
Bottom line, if you’re worried about risk, it pays to be an options seller rather than a buyer.
What types of stocks do you consider when searching for options plays?
Amber: I like to sell puts on inexpensive blue-chip stocks that are in an uptrend. Most pay dividends, but they don’t have to for me to earn income on them. These kinds of stocks make great long-term investments and are perfect for my options strategy.
Just about every blue-chip stock is “optionable,” meaning I can buy and sell options on the stock with ease. The options for these types of companies tend to be more liquid. Liquidity is one of the ways I reduce risk because that lowers trading costs and ensures that there will always be a buyer when it’s time to sell.
Blue chips are also less risky to own than lesser-known small-cap companies. The chance of a blue-chip company going into bankruptcy overnight is small. That does happen, but it tends to be a process that unfolds over several months. By using short-term options I have very little risk that a stock will fall to zero in the time I am trading it.
I also reduce risk by selling puts on stocks that are going up. Bad things rarely happen to large, well-managed companies when their stock price is undervalued and rising. There were many opportunities to get out of big banks during the 2008 financial crisis and traders who ignored the trend-reversal lost small fortunes. I avoid that risk by avoiding stocks that are in clear downtrends.
What do investors need to know before they can start selling options for income?
Amber: You will probably need to contact your broker if it’s your first time selling options.
Almost all brokers allow options trading, but there’s a catch in that you might need to request approval first. This can be done with a form that asks questions about your income and investment experience.
A few brokers require minimum account sizes. That’s okay, because they’re trying to ensure you have enough cash for when you get “put” a stock (meaning, you have to buy it). That’s why I think most people should have a decent portion of cash sitting in their account once they’re up and running.
For example, let’s say you sell a put with a $25 strike price. In most cases, the options will expire worthless and the trade ends there. But if the trade doesn’t pan out and the stock falls to $25 (it happens occasionally). All of a sudden, you’re “put” the stock, and you’ll be required to buy $2,500 worth of shares.
But if we’re comfortable owning the stock at that price, then fine. That’s also why it also pays to keep close tabs on your positions, in case you want to close out of the trade before that happens.
What are the benefits to trading this way?
For starters, let’s talk about the payoff… As you know, volatility affects options prices. So sometimes we may be talking about 3% or so on a trade, other times, it may be more. Either way, it adds up quickly, because we rarely remain in a trade for longer than six weeks. And once we’re done, we move on to another similar trade.
Making quick income trades like this allows you to remain nimble in an uncertain market. If things ever get crazy, you can always walk away from the table.
I’ve personally used the tools we use to identify our trades over at Income Trader for years. It’s my preferred method of trading, and it’s allowed me to generate more than enough income for me and my family. And I know many of our subscribers would agree, too.
Editor’s Note: I’d like to thank Amber for joining me today. I should note that Amber and her subscribers over at Income Trader have built a track record unlike anything I’ve ever seen… a 90.5% win-rate on their trades. That’s partly thanks to Amber’s award-winning indicator, but also because she’s just that good at what she does.