With interest rates at their lowest point in history, once safe income-producing assets such as and year Treasury bonds have seen their yields plunge to pitiful rates that are just high enough to keep up with inflation.
In other words, fears of a potential dividend stock bubble have many people wondering where they can turn to generate solid returns while controlling downside risk. Fortunately, stock options offer such investors some useful tools to meet their income, and risk control needs. And unlike what some people may think, not all options are high-risk, leveraged, speculative bets on the short-term movements in stock prices.
Stock options are merely contracts in which the writer of the option i. In other words, you can think of them as forms of insurance, in which the buyer of the option guarantees themselves the ability to buy or sell shares at a guaranteed price. As the writer of the option, you serve as the insurance company, and receive an upfront premium for entering into the contract, and thus either tying up your shares, or your cash, for a predetermined amount of time.
Options are an incredibly versatile tool, with literally dozens of differing strategies for investors to use in any kind of market scenario, and with various different goals, such as capital gains, income, buying shares at a discount, selling them for a higher profit, hedging downside risk, or using leverage to boost gains.
While this list may seem daunting, in reality these strategies are mostly just combinations of the two most basic forms of options: This article will focus on the two most basic, conservative income strategies based on these two options strategies: For more detailed explanations of these, or other, more advanced strategies listed above you can click here.
In other words, the edge belongs to options sellers aka writers. A put is a contract you can sell to generate income, OR to buy shares at a lower price.
Specifically these contracts obligate you to buy shares per contract at the stated strike price if shares trade below that level by the expiration date. You can either write a naked put, or a cash secured put. Naked simply means that rather than setting aside enough money in your brokerage account to pay for the shares, you are using other assets, including shares of other companies, to cover the margin maintenance requirement. This is a form of leverage that can easily get you in trouble should the stock move against you; potentially risking a margin call.
That occurs if the value of your portfolio falls below a certain level, set by Federal regulations. In the event of a margin call you either have to add more money to your account, or your broker will automatically sell your other holdings to come up with additional funds to meet the maintenance requirement.
In other words, this is a highly risky and speculative use of options that I advise all long-term dividend investors to avoid see five other risks dividend investors should avoid here. A cash secured put on the other hand, involves keeping the necessary money to buy the shares in your account and waiting to see whether the option will be triggered, or expire worthless; meaning the share price is above the strike price at expiration.
In that case you keep the premium, which represents the income you generate from this strategy. This kind of price incentive selling can result in selling at the exact wrong time i. Say you believe that Pfizer is a great long-term dividend growth stock that is currently undervalued. Because of this undervaluation the chances of Pfizer falling dramatically are lower, barring a strong, broad market correction. By selling puts you can buy shares at an even steeper discount, OR should shares stay at current levels or rise before expiration, you will generate potentially solid income.
Now keep in mind that this APR is only for the 35 days of the contract. To actually earn that high of a yield would require selling 12 such contracts, one each month, for the exact same terms, and each of them expiring worthless; a highly unlikely event. Thus the risk of assignment is lower, and you earn a proportionally lower annualized yield of 4.
That is mainly for two reasons. With a covered call, you already own the shares and will get the dividend unless the share price is above the strike price and the owner of the option wants to exercise his right to buy your shares before the expiration date to get the dividend. There are several factors that affect option premiums but the largest is volatility.
That makes sense because selling options is a form of insurance. Volatility is a proxy for risk, and as with insurance, premiums are higher if the risk is larger. In such a case you might not mind your shares being called away, especially since it would be at a higher price. If the price rises above it, then your shares will get called away i.
So in this case you think that the chances of JNJ rising are small, and you are getting paid 3. While selling cash covered puts and covered calls are among the two lowest risk option strategies available, nonetheless there are some risks involved you need to know about, specifically: Event risk is the probability that the underlying share price will move sufficiently to trigger the exercising of the option by its buyer.
In other words, the chance that you either end up buying the shares or having them called away. This way event risk becomes a feature, not a bug. Financial risk is the risk of the share price falling far below the strike price. For example, with cash secured puts you could end up assigned shares at a substantial paper loss, right from the start.
Now remember that you are still better off than had you simply bought the shares at the market price, since your cost basis is reduced by the premium. However, cash secured puts are not a strategy that helps in the event of a massive market correction. If this is a major concern for you then I recommend you do further research on Bull Put Spreads , which involve buying a lower strike price put that acts as a hedge against a crashing share price.
Finally, opportunity risk is involved with all option strategies, and is unfortunately not something you can avoid. For example, when selling a cash secured put, the optimal profit occurs if the underlying share price is above the strike at expiration. However, imagine selling a put and then watching the market rally strongly, the undervalued shares of a company you like rocketing upwards. In such a scenario the premium you receive might appear pitifully small in comparison to the gains you miss out on by not simply buying the shares in the first place.
Similarly, selling a covered call has both financial and opportunity risk. Imagine that you sell a covered call on a stock you think is highly overvalued. If the share price then plunges then you potentially stand to lose a lot of patiently accrued unrealized capital gains.
With options, as with all investing, there are opportunity costs that come from an uncertain future. In addition to the three risks described above, there are four important details to remember about options. First are trading costs. This brings up a second point, selling options for income generation is most profitable if you spread out the lowest possible commission over as many contracts as you are comfortable selling.
Of course, because each contract represents shares that means potentially obligating yourself to buy several hundred, or even thousands of shares, which requires massive amounts of capital. Similarly, selling even a single covered call assumes you have at least shares of a stock you are willing to sell.
All option income, even that generated by selling contracts with a duration over one year, is taxed as short-term capital gains. That means at your top marginal income tax rate. Which is why income generating options strategies are best done in a tax sheltered account, such as an IRA. Two other things to note with options and taxes.
If you are assigned shares by a written put, the option premium does indeed reduce your cost basis when it comes time to calculate taxable capital gain.
One other point to keep in mind. Because of the factors that determine premium size, options are best written on high volatility stocks, preferably highly liquid blue chips. So their option premiums are generally too low to make it worth pursuing the strategies described in this article.
And since options markets are less liquid than the stock market, trying to write options for small, less well-known companies can mean running into problems having your limit order filled.
Options are merely one tool to help long-term dividend investors meet their financial goals. That being said, if you understand the details and risks entailed by options, they can be a powerful tool. And when used in concert with high-quality dividend growth stocks, options can help you accumulate shares cheaper, as well as generate income in a sideways or slowly changing market.
So if you have the interest, time, and sufficient capital to manage the risks involved with these powerful financials tools, conservative, income generating option strategies may be something to consider using to increase the long-term returns and income generation of your diversified, long-term dividend portfolio.
Simply Safe Dividends T This provides a cheap way to profit if the stock rockets up. But in many cases the stock does not rocket up sufficiently to reach the strike price, and so the aggressive Bullish strategy fails, and the call expires worthless. The point is that the high expiry rate is not because the investor is buying rather than selling ; it is because option buyers set strikes far out of the money, hoping for a windfall, and often fail.
I imagine that the different tax treatments of different types of investment make it necessary hire a CPA no? No Turbotax users here!
I sold covered calls in the past but the idea of income overcame me and I was buying stock just to sell calls on. In that instance you are moving away from the concepts of Dividend investing and moving toward speculation, ie buying and betting on direction stock price movement. When I speculate I generally lose. I only sell calls on stock I own, and they are Dividend stocks. I will also watch closely as the I get to the end of my contract. I usually write week contracts and sometimes may buy them back and resell in the same contract period.
I wrote a GM call the end of last week that yielded only. If I do that 4 times a year I add 2. I see no reason that I cannot do that times a year coming close to doubling my yield. You raise a great point about the ever-present temptation to chase income. Buying stocks just to sell calls on them defeats the risk-avoidance purpose of selling covered calls in some ways.
Like you said, staying patient, sticking with an easy and understandable strategy, and consistently executing are all keys to long-term investing success. Thanks for sharing your experience!
What is Simply Safe Dividends? How does it work? How much does it cost? What are Stock Options? There are Many Different Types of Options Strategies Options are an incredibly versatile tool, with literally dozens of differing strategies for investors to use in any kind of market scenario, and with various different goals, such as capital gains, income, buying shares at a discount, selling them for a higher profit, hedging downside risk, or using leverage to boost gains.
Here are some common types of options and strategies you might have heard about before: Puts Calls Put spreads Call spreads Butterfly spreads Condor spreads Iron Butterfly spreads Iron Condor spreads Diagonal Call Spreads Various combinations of the above While this list may seem daunting, in reality these strategies are mostly just combinations of the two most basic forms of options: Cash Secured Put Example:More...