As many other investors eyeball rising risk in the general stock market, you should be using this opportunity to pick up some near-term cash.
In my recent book, Income for Life, I detail a series of investment strategies that can help you generate more income, even many non-traditional income ideas.
Today, I want to share an excerpt from the book that you should find of value for more investment income with reduced risk.
Looking Back to Look Forward
Traders, with their Hewlett Packard 12C or my preferred 17B calculators along with pocket protectors and slide rules (yes, I still have one from my prep school days), have always tried to codify risk so that they might convince their prey—you, the investor—that risk can be mathematically measured, managed and controlled.
Managed enough, of course, so that you might be willing to separate yourself from your cash and put it into their funds and stock picks.
One of the principal means of measuring risk is to look at the past ups and downs in market indexes and individual stocks and funds to come up with a rate of change, also called volatility.
And, of course—just as the fine print says at the bottom of any mutual fund or other financial product—past performance is no guarantee of future performance.
This doesn’t stop the bulk of professional and amateur investors from focusing on volatility.
Investors frequently look at volatility when it comes to pricing hedges and trading vehicles to try to cash in on changes that might come in the future based on what has been happening over the past several days or weeks.
This is particularly true when it comes to stock options. But there is an easy way to use these derivatives to boost income safely.
An Option Income Option
Now, I’m not writing about the kind of options that are used to pay those C-suite players in public companies.
It never really seems to matter whether the underlying markets go up, down or whatever for those kinds of options. The executives always manage to find a way to make money for themselves.
Rather, I’m writing about regular stock options—many of you are already familiar with them—the puts and calls that trade in the regular derivatives markets, giving the buyer and seller the ability to buy or sell the right to buy or sell a particular stock at a particular price for a particular period of time.
What Is an Option?
But before we go down this road, a little bit about what options are and aren’t for those who are new to options.
As I mentioned, an options contract (like a futures contract) is a derivative. That means it derives its value from an underlying asset. In the case of stock options, they derive their value from the underlying stock they represent.
Options valuations and pricing can get pretty complex pretty quickly, and for a simple options strategy, it’s best not to go down this road.
Simply put, stock options give investors the ability to work the markets to accomplish numerous goals, which can include speculating on the near-term direction of a particular stock to buying insurance in case of a fall in the market price of an individual stock holding.
There are three simple strategies: Puts, calls and covered calls.
A put option is a bet that a stock price will move down. A call is a bet that the price will move up. And a covered-call write, which is what I want to share with you now, is a way to use a solid stock you already own to make some extra cash.
Get Some Cash from Covered Calls
With covered-call writing, you sell an option on a stock you already own, which gives you a premium over the course of the contract.
Let’s say you own 100 shares of XYZ company at a price of $10 a share. You’re concerned that the price might fall for a bit or stay where it is, so you sell a call, giving someone the right to buy the stock from you at $10 a share for the next month.
For doing that, you get paid $1 a share. Since an option controls 100 shares, you would get $100.
This trade can play out in several different ways.
First, the stock price of XYZ goes nowhere, and after one month, the options expire. You keep your shares and the $100 that you got for selling the calls.
A second scenario might be that the stock price falls to $9. Again, you would keep your shares of XYZ and the $100 for the calls.
A third scenario is the price of XYZ goes up to $12 a share. Your stock gets bought from you at $10 a share, and you get to keep the $100 from the sale of the call.
Granted, in the third scenario, you miss out on the extra $1 per share price gain, but you still manage to make an extra $1 a share ($100) from the sale of the option. If XYZ is still a good deal, you can just buy more shares.
It’s the third scenario that’s the rub for covered-call sales. You limit your upside in a bullish market.
It’s All About Timing
The key to knowing when to sell covered calls on one of your current stock holdings is to look at not just the overall market outlook for your stocks but also how the options are being priced.
Options are priced based on the amount of time the options have before expiration—the longer the time before expiration, the higher the value.
Then there’s the actual value of the options—otherwise called intrinsic value. If a call has a strike price lower than the stock’s current price, the option has intrinsic value.
But the big factor, and why I’m suggesting looking at doing this right now, is volatility. The market looks backwards to the stock’s price history and then infers a value to that for the life of the option.
As volatility rises above the pricing average, the option price gets pricier. When volatility falls, the option price falls.
When volatility increases for a stock (or on the market in general), options prices go up too.
Covered call sales are a good way for investors to take advantage of increased option prices. They can get well paid to limit their upside and take cash for their trouble.
Neil George was once an all-star bond trader, but now he works morning and night to steer readers away from traps — and into safe, top-performing income investments. Neil’s new income program is a cash-generating machine…one that can help you collect $208 every day the market’s open. Neil does not have any holdings in the securities mentioned above.