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The most common method for making money in the stock market is to buy low and sell high. That’s what you’ll hear from even the common person walking the street who has never held a share.

Our preferred method for earning a living around here is called Dividend Growth Investing (DGI). This is where you buy shares of quality companies and allow them to increase the amount of cash flow they send you year after year. It’s a great way to passively cash flow your way to financial freedom.

One of the issues that goes along with stock market investing, however, is that oftentimes the companies you would like to buy are just too damn expensive. When I first started out as an investor I thought that you just had to wait until the company you want goes on sale at a lower price. I kept hearing about patience, patience, patience. While a healthy dose of self-control is a good thing, I started looking to improve my strategy.

The Basics of Options

In my search for the elixir of profitability, I stumbled across options. In the stock market game there are two types of options that investors are able to use. Call options relate to a stock going up and put options relate to a stock going down. I have only ever used put options.

As per Wikipedia:

“…A put or put option is a stock market device which gives the owner of the put, the right, but not the obligation, to sell an asset (the underlying), at a specified price (the strike), by a predetermined date (the expiry or maturity) to a given party (the seller of the put).”

I hope I didn’t lose you there. To simplify matters, just think of selling put options as selling insurance.

Strategy

Selling put options is fundamentally a way for a DGI investor to get paid to wait. It’s a useful tool to have in your bag of tricks once you understand it since harvesting premiums is one additional way to generate a stream of income.

Each option contract involves 100 underlying shares. The buyer of one put option gains the right to offload 100 of their shares of a specific company to whoever has sold them the put option (it is all handled through exchanges the way buying and selling stocks is) in the event that the share price goes below a certain point (the strike price). In exchange for gaining this downside protection, the buyer of the put must pay the seller a premium.

For the above reason and as noted, I like to think of myself as selling insurance as a seller of puts. It is a way for me to take on someone else’s risk in exchange for a fee.

Now here’s the key point and the rule I never break: I only sell put options on shares of companies that I want to own. Since the possibility exists that I may have to actually buy the 100 shares if the option is exercised, it is only logical to do this exclusively with companies I actually intend to hold onto.

Put options pay higher premiums when the market is going down than when it is going up. When people are fearful that stocks will keep declining they are more inclined to pay high premiums to insure themselves.

Real Life Example

The best way to learn things is often to see the theory put to the test in practice.

A few years back when the market was much lower, I decided that I wanted to own shares of Waste Management, Inc. (WM). The problem was the price. It was too high for my liking. Sitting around ~$37 per share, I didn’t want to buy a full position in the company. Still, I would have been kicking myself if I simply sat on the sidelines and the shares went up in perpetuity – which would have left me out in the cold without any stock.

I decided this was the perfect opportunity to sell a put option. I consider my strategy a bit of a hybrid because what I actually like to do is buy some shares and then also sell a put option which means even if the stock goes up forever, I will have some exposure to the shares while also pocketing the premium.

As a result, I bought 50 shares and immediately also sold one put option with a strike price of $35. The expiration was set for roughly two years away (known as a LEAPS option). I was paid a ~$500 premium factoring in commissions. This meant that while already owning 50 shares, I would either,

  1. If the stock was exercised below the strike price: Acquire 100 shares with a cost of $3,500 (100 shares x $35). My net cost would have been actually $3,000 for the shares ($3,500 – $500 premium). The end result would be 150 shares.
  2. If the stock price went up: Pocket the $500 premium and just have my 50 shares that I purchased already.

Option 2 is what actually happened. The share price declined well below the strike price to around $29 as I recall but the option was never exercised. The shares subsequently rose back up and are roughly $54 at the time of writing. I still have my shares and made nice returns when factoring in the capital gains aspect (on paper, of course), the dividends I have been paid, and the initial premium I collected.

Conclusion

To summarize, here are a few reasons I believe selling put options is better than buying them:

  • Time is on my side: The seller of a put option gets paid a premium immediately and can use that money right away if they like. Once the expiration date passes, that money belongs to the seller. On the other hand, the buyer of a put option pays a premium and has to worry about their option expiring. Once it expires, their premium has effectively gone to waste if the shares did not decline. This is very speculative and can be costly.
  • Buying insurance makes no sense for a long-term investor: As far as I am concerned, if you feel the need to buy insurance to protect your downside, the stock market is not the place to be dabbling. Buying insurance impairs your ability to get outsized gains because you are bleeding money in premiums. With stock ownership, I prefer to be all in with companies I believe will stand the test of time.
  • Getting paid to wait: With my hybrid strategy, it is possible to get the upside if the stock goes up forever since I hold shares while also reaping a premium at the outset. If the shares do go down, I benefit from gaining another 100 shares at a lower price.

I spent many hours reading and learning about options before I ever dipped my toes into the water. This strategy is not for everyone though it has served me well in the past. I hope to use it again when premiums are elevated if the market takes a tumble.

Thank you for reading,

Ryan

Have you ever used options to supplement your stock investing strategy?

Full Disclosure: Long WM.

I was inspired/reminded to write this post after reading this article over at DivHut – a friend of this site. I have to admit that few industries get me as excited as the waste removal business when it comes to investing. This is as vital a public necessity as there could be since everyone produces waste which means someone needs to be there to take it all away. In a society as wasteful as ours, that’s a good thing for a quality operator.

Pictures courtesy of pixabay.com

8 thoughts on “Get Paid Selling Options

  1. Interesting options strategy. I tend to sell puts about 45 days out and then buy them back when there is at least a 50% profit or roll them out if the put is threatened. I’ve found the 50% profit mark usually happens before 20 days or so, though I did have one month where a few puts reached that threshold within just a few days. That was a good options income month! I’m usually using this strategy to profit from the option’s premium rather than to own the underlying stock. Though, in a few years, I hope to sell puts to ultimately own the underlying stock as well.

    Your method of buying a half position and then selling a put option is something that I’ll have to look into. Why did you decide to sell LEAPs? Do you feel that the $500 you received was more than what you could have gotten from selling multiple puts with earlier expiration dates? Thanks for the tips!!
    Scott @ TwoInvesting recently posted…April 2015 IncomeMy Profile

    1. Hi Scott,

      Thanks for stopping in and providing some interesting feedback.

      I’ve used LEAPs because the premiums are higher since there is more time value attributed to them. Since I use this strategy for longer-term plays, I am okay waiting a year or two to collect either additional stock at lower prices or simply keep the premium. This also saves me from getting burned on commissions from regularly speculating on option values. I shy away from speculation as much as possible.

      Why is it that you plan to wait a few years before using options to establish positions in stock you’d like to own?

      – Ryan

      1. The few puts that I’ve sold so far I did with the intention of not owning the stock (though each was cash secured). I was just happy to collect the premium.

        I’m going to have to wait a few years until I move into a higher paying job. I just can’t afford to buy many stocks in lots of 100 shares at this point.

        1. If you can consistently reap profit from premiums and are doing well with it, then all power to you.

          It can definitely be daunting to play with options on stocks with high prices. My put on Waste Management was in the mid-$30s, so it would have been a relatively small $3k commitment if I was exercised after backing the premium out.

  2. Allan says:

    Hi Ryan,
    That’s an interesting strategy for sure. I will take note of it and dig a little more into it eventually.

    Thanks for sharing
    Allan recently posted…The Best way to invest 10000 $My Profile

    1. Allan,

      It’s a strategy I devised so that I am still able to get skin in the game no matter what (initiating a starter position) while also benefiting from the use of options. It’s a win-win when used properly.

      Thanks for the comment,
      – Ryan

  3. DivHut says:

    Thank you very much for the DivHut mention. Much appreciated. Thanks for sharing your real world LEAP transaction as well.
    DivHut recently posted…Dumpster Diving For DividendsMy Profile

    1. DH,

      No problem, brother. Thanks for stopping in.

      – Ryan

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