A Simple Option Trade
I recently discovered a simple, high probability option trade that so far I have really liked. If you have read my past posts, you will know my journey with Robinhood option trading and the crazy ups and downs of buying calls and puts and also more complex strategies like straddles, strangles and iron condors. Like most people who try these strategies, my results weren't very good and resulted in mostly losses. I'm not sure experience really helps, since you are pretty much relying on luck when you enter most of these trades. That's why I compared it to gambling in my post entitled Free Trades May Cost More Than You Think.
Staying with the gambling analogy, there is another strategy where you are more like the "house" with the odds in your favor and this is selling covered calls. Selling a covered call is basically selling the right for someone to buy shares of a stock you own at a set price that expires at a certain time. The buyer pays a premium to you for this right in cash. The calls are "covered" because you own enough of the underlying shares to sell, should the contract expire "in the money" and the shares are purchased. You can also sell calls "naked" or not covered, but I don't recommend that at all.
Say you want to own a dividend paying stock like Coke, which currently yields about 3.6% and has a strong likelihood of being able to continue to maintain that dividend, even in the current recession. While that's a nice dividend, you'd like to make a little more. Coke currently trades at $45.11 per share, so you can buy 100 shares for $4,511. You will earn $162 a year in dividends - passive income without you having to lift a finger.
You can also sell a covered call on Coke with a $47 strike price, expiring in about two weeks on June 5 for $0.18 per share (one contract is 100 shares so you would get $18 of premium for selling the call). If Coke is trading below $47 on June 5 (86% chance of this happening according to Robinhood option quote), you keep the premium and nothing happens to your shares. Another way to look at this is there is a 14% chance that the option expires in the money and you have to sell your shares. If you did that every two weeks, you could make an extra $468 per year, almost 3x the dividend! There are calls that have a higher probability of profit, but you get a lower premium since they are lower risk. For example, you could sell a call with a $49 strike price and same expiration date, but you would only get $11 for that one and a 93% chance of profit. If you can get 90%+ probability of profit and a premium you are happy with, then it's likely a good trade.
If the stock is trading above the strike price on the expiration date, then you will get "exercised," which means your shares will be sold for $47 per share at that time. You still get to keep the premium of $18 plus you will get the proceeds from the sale of shares ($4,700) and have a gain on the sale of your shares of $189 ($4,700 - $4,511), so you would have made a total of $207 ($18 + $189) and you still have your original investment money. As long as you don't sell calls with strike prices below your cost basis, you will make money in the unlikely event the option is exercised. If you sell your shares for a loss and buy them back right away, you could lose the ability to deduct the loss on your tax return (called "wash sale rules") so that's something to be aware of and to talk to your CPA about.
I like this strategy for earning extra cash flow on stocks I want to keep long term. If you keep the duration of the option short - like only one or two weeks, you'll have a higher probability of keeping the premium but of course will earn less of a premium. The only "loss" you incur if you are exercised is the opportunity cost of being able to sell your shares for a higher price (the difference between the market price and the strike price at expiration). In a declining market, this is a great way to make extra money above your dividends. In a rising market, while there's a higher chance of getting exercised, you have the option to repurchase your shares (albeit at a higher price) or buy something else and repeat the process.
At certain times, like around earnings, stocks become more volatile and option premiums can be higher than they are normally, but so can the risk of exercise so you have to use judgment when selling calls into earnings. There's a great covered call screening tool at Barchart.com. You can study the different trades to see which ones have the best return probability. Of course, there's a chance you buy a stock and the price drops significantly, which could be a problem if you aren't willing to hold it, but at least you would keep the premium. Hertz was high on this list a week or so ago and now they are in bankruptcy and the stock is down significantly, so you do need to be careful and do your research on stocks that pop up on screeners like this. I prefer to invest in solid, conservative dividend yielding stocks so the call premiums may not be that great, but overall it's less risky.
I hope you find this post useful as you chart your personal financial course and Build a Financial Fortress in 2020. Stay safe, healthy and positive.
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