Ever wonder how to further enhance your investment return? Look no further! As a bottom-up fundamental investor, we’re particular sensitive to prices and valuation ranges we want to acquire/sell stocks at to maximize our risk-return profile.
As a result, we are often faced with two common situation in our portfolio.
Firstly, a situation where we already own the stock and would like to add more, but adding at the current price doesn’t provide the risk-reward of our liking. Secondly, a situation where we own the stock and have a target price and valuation in mind which has yet to be realized.
One way to do it is to utilize options, specifically option strategies for consistent income. In essence, we're paid to wait, as you will see later. In this article, we share our view on how to sell options safely for consistent income.
The subject of options is often very mathematical. For this article’s purpose, we avoid anything too technical (greeks) and revisit the concept later.
So, what are options? Options are derivatives where its value derives from the underlying, ie stocks. In return for a premium, buying (selling) a stock option gives you the right but not the obligation to buy (sell) stocks at a pre-determined price and time. Typically, an option contract represents 100 underlying, ie it gives the holder the right to purchase or sell 100 stocks per contract.
There are two main types of options: call options and put options. Colloquially, we use long and short interchangeably with buying and selling, respectively.
For readers who are familiar with options, feel free to jump to the yield enhancement strategies section.
Call option gives the holder the right but not the obligation to purchase a stock at a pre-determined price (strike price) and expiry date. For example, an Apple Inc. call option at strike $500 expiring January 2022, allows the holder to purchase stocks at $500 over the period up till Jan 2022.
For convenience, we group call options in three groups.
- At-the-money (ATM) call: Strike price equal to the current stock price.
- In-the-money (ITM) call: Strike price less than the current stock price.
- Out-of-the-money (OTM) call: Strike price greater than the current stock price.
Clearly, the holder (buyer) of a call option will profit only if the stock is trading above $500 and vice-versa. In addition, a call option holder has unlimited upside potential, scaling with increasing stock price.
Call option buyer’s payoff = Max(S – K, 0) - P
S = stock price, K = strike price, P = premium
One can also sell call option. In this case, the call option seller profits when the stock price is less than the strike price. The call option seller’s max profit is the premium collected, P.
Call option seller’s payoff = - (Max(S – K, 0) - P) = P – Max(S – K, 0)
Contrary to call, put option holders have the right but not the obligation to sell a stock at a pre-determined price and expiry date. For example, a Pinterest put option at strike $40 expiring January 2022, gives the holder the right to sell the stock at $40, regardless what the stock is trading at, up till Jan 2022.
With put options, the moneyness grouping is the opposite of its call counterpart.
- At-the-money (ATM) put: Strike price equal to the current stock price.
- In-the-money (ITM) put: Strike price greater the current stock price.
- Out-of-the-money (OTM) put: Strike price less than the current stock price.
Put option buyer’s payoff = Max(K – S, 0) - P
In our example, put option holder will profit only if the stock is trading below $40. Theoretically, a put option holder’s maximum profit is K - P, assuming S goes to 0.
Similarly, one can also sell (short) put option, which profits if the stock price increases. The maximum profit from sell put is the premium collected, P, while the maximum loss is P-K.
Put option seller’s payoff = - (Max(K – S, 0) - P) = P – Max(K – S, 0)
To summarize, options are leveraged products that can amplify your gains or losses. The cost of selling naked options (without hedging) is the margins or capital required to be set aside at the beginning. Consequently, this may dilute the goal of maximizing return on capital.
Yield enhancement strategies
Now that we have a basic understanding of how options work, let’s explore how investors can incorporate options into their investment strategy. The option strategies we’re about to discuss are aimed at enhancing yield and return, rather than outright speculations.
A covered call is when an investor owns the underlying stock, while selling equivalent OTM call options. For example, owning 100 stocks of Pinterest, currently trading at $35, while selling 1 contract (100 stocks per contract) OTM call option with strike of $45.
Often when owning stocks, we have a price target (usually ambitious) that we would be willing to sell the stocks at. By selling OTM call options that matches your price target, it not only gives you the premium while waiting for the price target to be reached, but it also encourages discipline profit taking in one’s investment process. Assuming that the price target was never reached, it can potentially generate a significant uplift in income for the investment.
Here’s an example of how it works. Assume we purchased 100 stocks @ $35 and sold a call with strike of $40, which yields a premium of $70. Then, the payoff diagram is as follows.
As discussed, the key advantage here is that it allows investor to generate additional income. On the other hand, the key disadvantage is that it caps your gain. Notice that in the covered call payoff diagram, the gains are capped at $40. One way to work around this problem is to sell calls with higher strike (receiving less premium, of course!).
A covered call is a popular and conservative option strategy because the underlying stocks you hold will act as a hedge should the call option be in-the-money. Consequently, this strategy requires little to no margin because you hold equivalent stocks for each option as a hedge. Hence, why this is popular.
Long stocks + short puts
Another strategy we use (with caution) to enhance yield is to sell OTM puts while owning the underlying stocks. Similar to covered call, sell OTM puts provides an income stream.
The idea behind this strategy is a situation when you already own a stock and want to own more of it, but at a lower price. For example, owning 100 Apple stocks and aiming to buy more if the stock falls by 20%, say.
This strategy involves owning the underlying stocks while selling OTM puts with a strike price that you’re willing to add more to your holdings. Here’s how the payoff diagram will look like.
There are, however, some downside to this strategy. First, selling puts means you are agreeing to buy the stock at a certain price, if it reaches that target or below. There is a risk that the stock will fall significantly below the strike price of the put option sold. Consequently, this can incur a significant loss and require cash to fund the purchase.
As an example, say Apple is trading at $450 today and you own 100 of them, and sold a put option with a strike of $400. Should the price falls to say $390, you would need $40,000 (100 stocks * $400) to fund the purchase, since it is an obligation if the option is exercised. Additionally, there will be an immediate unrealized loss of $1,000 (($400-$390) * 100 stocks).
Secondly, because this position is unhedged, selling puts will incur significant upfront margin. Overall, this strategy requires significant amount of capital at inception. Selling puts while owning the underlying stocks is often seen as a more aggressive version of covered call.
Risk of option strategies
Our objective is to share and create awareness on how we manage our portfolio using option strategies for consistent income. While the upside is clear, such option strategies may not be suitable for all investors. We highly recommend interested investors to fully understand how options work and the risk of option strategies before implementing them.
Yield enhancement strategies using options do not come for free. The risk involved may include unlimited liabilities, hence, the understanding of how options work is paramount.
Conservatively, our investing approach offers the opportunity for yield enhancing strategies using options. We used covered calls when we look to sell shares at a particular price. Selling puts while owning the underlying stocks is a more aggressive strategy for us to accumulate more shares should the price falls.
In investing, every little helps!