This Incredibly Boring Options Strategy Brings Me Incredibly Boring Income
Options trading used to scare the living daylights out of me.
It conjured two unpleasant images in my mind. One was the sleazy but cliché video ads for so-and-so’s Millionaire Secrets Trading Course. The other was the desperate soul losing years of savings to one afternoon’s market fluctuations because leverage does indeed work both ways.
Hardly aspirational in either case.
(It also conjured a third image — that of the uber-quant with seven monitors and a tattoo of the Black-Scholes equation — which is somehow the least relatable of all.)
But as more of my real-life and online acquaintances saw steady success in this baffling financial market, I thought it was worth a second look. Or, more accurately, a first real look.
I discovered it was not so inherently dangerous at all. Many conservative and comprehensible approaches actually perform well for certain goals. By implementing a couple of these, I’ve slowly but steadily built cash flow that complements my long-term investing.
None of it requires elaborate analysis or all-day monitoring, none requires more than a few thousand dollars to start, and none undermines my minimalist approach to personal finance.
In other words, it’s beautifully boring.
Writing options, the safe way?
Now, nothing in here is financial advice. I am a hobbyist trader, nothing more, and I share this only as a journal and perhaps a conversation-starter.
With that said, my big options-for-income revelation was the simplicity of covered calls and cash-secured puts.
If those are old hat to you, then there’s little reason to continue.
But if those are new concepts, then the rest of this article might be of interest. (I recommend Investopedia for more detailed definitions and examples that are outside the scope of this article. There’s an abundance of good content on YouTube, too, but it’s awfully easy to follow it down unproductive rabbit holes.)
A huge benefit of writing (i.e., shorting) options is that you collect a premium the moment the transaction goes through. And it’s yours to keep. As long as they expire out of the money, you can rinse and repeat.
A fundamental risk
The thing is, they don’t always expire out of the money. Sometimes you’re assigned, meaning the buyer actually takes you up on the option you sold them.
It’s easy to see how that can spell disaster.
If you wrote a call on stock you don’t have, and the market price shoots up above the strike price, then you’re legally bound to purchase and resell it at a potentially massive loss.
Likewise, if you wrote a put without enough cash to fulfill it, then you’re in a tight spot when it’s exercised.
These are called “naked” options, and many overly optimistic traders have lost many dollars on them. Even if you write options that probably won’t expire in the money, there’s a world of difference between “probably won’t” and “can’t.” Worse still, the losses tend to be rare but massive.
My simple mitigation
There are a million ways to mitigate this risk, such as buying the same option at a slightly farther out-of-the-money strike price. For instance, you might write a $30 put and then buy a $28 put to hedge. But picking the right gap between the two can quickly get complicated. That’s unappealing to someone who’d rather minimize predictions and stay more hands-off.
But my approach has been simple and effective, with modest yet consistent profits.
For calls, actually own at least 100 shares (per contract) of anything you write a call on. Pick a strike price that you wouldn’t have minded selling it for anyway. Remember, that price is up to you, so don’t obligate yourself to a loss on that stock just for the sake of a higher premium!
For puts, ensure your brokerage account has at least 100 times the strike price in cash (per contract) before you even think of writing a put. Likewise, only pick a strike price that you consider reasonable to pay for the stock in the first place. In other words, think of it as a limit order.
If you wrote a call that is at-the-money or just slightly out on expiration day, then there’s a non-trivial chance that it shoots up at the last minute or after hours, and you wind up assigned. Assuming you chose a strike price you’re happy with, it’s really not a bad thing, plus you’ll have gathered a high premium to lower your cost basis (i.e., your average price per share). But if you’d rather avoid any surprises in the eleventh hour, then spend the few bucks to buy back and close the position.
In summary, selling options against collateral you own is one of the safest, lowest-maintenance strategies I’ve found.
Covered calls are a great way to reduce the effective cost of shares you already have. Likewise, cash-secured puts provide cash flow while waiting for shares you want to reach a price you like.
I actually use both: write a put on something I want, then write calls against it if I’m assigned (assuming I’ll sell it at a profit, of course). That strategy is known as the “wheel,” and while it has its drawbacks, it’s a simple and intuitive way to coax at least a few percentage points out of desirable holdings.
(Do keep in mind that different holding periods have tax ramifications, so talk to an accountant before you go writing covered calls against everything you own.)
I’ll post a follow-up around six months in, but I’d be surprised not to see upwards of 25% returns by that point.
So, what’s the catch?
The disadvantage is the inherent risk-return trade-off. By limiting risk, you’re necessarily limiting returns. But again, that’s basically the point.
The other possible issue is starting capital. The sort of companies you’d generally like to own are big and fairly stable ones. They usually have highly liquid options markets, good dividend payouts, and not a ton of volatility. Those don’t come cheap, though, so it’s easiest to start with at least a few thousand dollars. Index ETFs are also terrific for this approach, but most are significantly more expensive yet.
Conversely, inexpensive and volatile stocks have appealing premiums, but they tend to suffer from wide spreads and low trading volume. Snagging an appealing company through a $5-strike cash-secured put might be a great buy, but if the next strike up is $7.5, then it might be a while before you can profitably unload the stock and continue with the “wheel” strategy (if that’s your goal).
One final caveat is that you can still lose big if the underlying does something erratic. But that’s also true of plain old stocks, and it’s a risk that the frequent premiums help offset. As they say, don’t bet what you can’t afford to lose.
Boring is beautiful
In my experience — yours may vary — it’s an incredibly simple way to accrue a few percentage points each month based on your initial capital.
That’s miles ahead of any savings account or even high-dividend stocks, but it still doesn’t sound like much. It’s not the sort of return profile that excites the Lamborghini-and-mansion crowd.
In fact, it sounds downright boring…and that’s exactly why I love it.
I consider a bird in the hand worth more than two in the bush. Put another away, I’m happy to accept less upside if it also limits downside. That’s partly a financial thing, but even more a psychological thing. Complex back-testing and position management, followed by exhilarating highs and gut-wrenching lows, would distract from my other priorities.
This conservative approach looks more like value or dividend investing than your typical get-rich-quick options scheme. It’s remarkably unremarkable.
And that, I submit, is exactly why it has worked.
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