Trading Options 101: Collect a Better Yield (Not For Everyone!)
In matters of personal finance, income is king. But in today’s environment, generating income through yield can get depressing.
Treasurys, bank CDs and savings accounts are all yielding next to nothing. The only way to get enough income worth thinking about in Treasurys or CDs is to lock your cash away for five or 10 years. But even then we are only talking 2% to 2.5%.
Not the ideal scenario for someone looking for additional income.
Thankfully, there is a better way. One that helps you generate safe, consistent income each month — and you don’t even have to lock your money up for a year…
Get Paid to Buy
There’s a little-known and very underutilized strategy that essentially pays you to play the stock market whether or not you actually end up buying shares.
They’re called options.
Now, you’ve probably heard someone say that options are risky — certainly not the best avenue to take for investors trying to play it safe.
When you buy an option — specifically, a put option — you’re betting the stock will go down. If it goes up, you lose your total investment.
But I’m not talking about buying options. I’m talking about selling them.
When you sell put options, you’re betting the stock goes up, stays the same or falls just below where it is now. In doing so, you’re immediately paid a premium — just for selling the put option, regardless of the outcome.
By using this strategy, you can easily generate a yield of 12% or even more than 20% of your initial investment. And you don’t have to wait! It comes to your bank account right away.
Or you could just buy shares outright and perhaps make an annualized yield of 1%, 2%, maybe 3% from dividends.
Easy choice, right?
Let’s use Harley-Davidson Inc. (NYSE: HOG) as an example. Harley owns the iconic brand of motorcycles that are made in the USA. Even though sales have stalled in the U.S., it has a renewed push to increase sales overseas, and that will boost sales and profitability in the years to come.
This was a recommendation I gave to members of my Pure Income service a few weeks ago, with the price of the stock trading around $52.50, near where it is today. So that was what they could have paid right then for shares in the company, and began collecting its 2.8% annual dividend yield.
Or, and this was my recommendation, you can use the put-selling strategy to collect upward of 15% yield right away.
Let’s walk through what can happen.
Collect a Better Yield
First off — and this is the most important thing — you only want to use the put-selling strategy with a company you actually want to own, even if you have no intention of buying it.
When you choose your put option’s strike price, which is below the price at which the stock is currently selling, you’re expecting the stock not to fall that low. That way, nothing happens to you — you don’t buy the stock, and you walk away with the premium you were paid just to engage in the contract.
But even if the price of the stock does fall below the strike price and you’re forced to buy it, it doesn’t matter because you already picked a stock you are OK with owning, and you were paid a premium to do it.
But there is another important aspect to selling put options — using margin.
When you sell a put, you’re agreeing to purchase exactly 100 shares of the company if they fall below the strike price. But by using a margin account, which most brokers will allow you to do, you can get by with only depositing one-fifth of the capital — enough to buy 20 shares.
Of course, you have to make sure you have enough capital to purchase all 100 shares, but the great thing about put selling is that if the stock never falls below the strike price, that other 80% never leaves your bank account.
If you use margin on this trade, you can collect a 15% yield right now by entering into a three-month contract. By depositing some capital up front, you’re paid that premium.
Your alternative to using a margin account is to use what is called a “cash-secured account.” In this account, you deposit the full amount — enough for all 100 shares — collect the premium, and wait three months to either buy the shares or make the trade again, depending on the outcome. If you don’t want to deposit all the capital up front, use margin. You stand to accumulate a better yield on your capital this way.
Now, let’s make the trade.
Action to Take
When making the trade, pay close attention to the language. Make sure you are using put options and have selected to “sell to open” instead of “sell to close.”
All you have to do is tell your broker you want to sell to open the Harley-Davidson, August 18, 2017, expiration, $50 strike put option for more than $1.50. The option symbol for this is HOG170818P00050000. If the price is below that, wait until it is above it before placing the trade.
When your trade is placed, you will instantly receive $1.50 or more per share. Remember that an option’s contract equals 100 shares, so you would receive a premium of $150. If you sold five option contracts, it would be $750.
In a cash-secured account, you would deposit enough to cover the full amount, which is $5,000 for one contract. That is an instant yield of 3% with your capital only tied up for three months, or 12% annualized if you repeat the trade.
In a margin account, you would deposit about a fifth of the full amount, or $1,000, but still collect the same $150 for one option contract. This gives you a yield of 15% in three months.
Call your broker today and make this trade, and see for yourself just how easy and profitable put selling can be.
This is the advice I give my Pure Income subscribers every week, and with it, we’re able to generate safe, steady income — each month, all year.
Chad Shoop, CMT
Editor, Pure Income