When it comes to stock investing, there are 2 models which you can choose to adopt – either growth or income. The same principle when it comes to options trading. In this post, I’m going to be sharing about how you can use option to generate monthly income.
I remember when I first came across options, I thought it’s a risky derivative to get involved in. So, I was not open to this until I learned something from NLP Program that I joined during March 2018:
“The Law of Requisite Variety” – People with great flexibility have the best chances of getting the result they want.
In other words, if you want to generate income from stock market then you must be willing to try new strategies to achieve it. If the strategy does not work, it just means you should try another way until you get the result you want.
For me, value investing has always been my go-to strategy whether it is capital gains or income. But once you combine it with options, that’s where the game changed. You see, option is a contract between a buyer & a seller based on an underlying asset (e.g. commodities, ETFs or Indices). In this case, the stock itself.
There 2 types of option contracts – CALL and PUT option. You can either buy or sell these option contracts. But there are terms in the contract as summarised in the following chart, in the context of “stocks”:
Like any other contracts, there is a price for each contract. This is known as “premium”. Think of this as the legal fees for binding a contract but you are your own lawyer. So, you have to pay a premium if you want to buy an option contract. If you sell an option contract, then you will receive a premium from the buyer.
How then we can use option to generate monthly income? Simple, you need to be an option seller instead of buyer. There are 2 strategies you can use. In this article, I will share with you the first option strategy which is known as:
Cash Secured PUT Options
This strategy is about selling a PUT options on a particular stock. When you sell a PUT option, the terms of the contract states that you are obligated to buy 100 shares at an agreed price (a.k.a. “strike price”) within a specified time. In return, you receive a premium – Income to your pocket.
Imagine you are the interested buyer of a property which currently valued at RM500,000. But you don’t want to buy at current value. So, you approach the owner of the property and make a contract out of it.
The contract is such that you will buy the property at RM300,000 within 30 days in return the owner will pay you RM10,000 – income to your pocket. If ever the property value dropped below the RM300,000 within 30 days, you are obligated to buy the property at the agreed RM300,000 price.
But if after 30 days, the property value still maintained at RM500,000. The PUT option contract will expire worthless and you keep the RM10,000. What is your ROI out of this contract? It is 3.3% (RM10,000/ RM300,000 x 100).
Now let’s take the above example and apply it in the case of stocks. Imagine Adobe is currently trading at $475 per share. If you’re a value investor, you would know that Adobe is a great company to invest in. However, the valuation is expensive right now to invest in.
What you can do is sell a PUT option at a strike price = intrinsic value with a 30 days expiration date. Let’s say the intrinsic value is $450 and the premium that you will receive from selling this PUT option contract is $10. Below is the summary of the contract:
|Option Type||Sell PUT|
|Contract Size||100 Shares|
|Days to Expiration||30 Days|
|Total Premium Received ($10 x 100 Shares)||$1,000|
|Total Capital Reserved ($450 x 100 Shares)||$45,000|
There are 2 scenarios that can happen when you sell this PUT options:
1st Scenario – Adobe stock price went up to $500 or maintained at $450 after the 30 days
There’s nothing you need to do here because the options contract now has expired worthless and you keep the premium of $1,000 – income to your pocket. Your ROI from this is 2.2% ($1,000/ $45,000 x 100).
You can continue to do this every month collecting $1,000 and in a year’s time you would have gained an ROI of approximately 26% simply by selling PUT option on Adobe.
2nd Scenario – Adobe stock price went below $450 within the 30 days period
In this case, you have the obligation to buy 100 shares of Adobe at $450. This is because when you sell a PUT option contract, you promised to buy 100 shares when the buyer exercises his right to this contract. But you wouldn’t mind buying it because you know Adobe’s intrinsic value is at $450. Eventually, the stock will grow since it has a good business model. Plus, your costs are actually lower because you received a premium from selling PUT option (see below).
|Total Costs ($450 x 100 Shares)||$45,000|
|Total Premiums Received ($10 x 100 Shares)||$1,000|
|Net Costs (Total Costs - Premiums Received)||$44,000|
As you can see from the above illustration, you win regardless of the scenarios. This is the first strategy that you can use to generate monthly income. Of course, you can only use this in US stock market. There are no options in Bursa Malaysia. The bad side of this strategy is that you need to have a big capital reserved for when the PUT buyer exercise his right to sell you 100 shares of a particular stock.
The second strategy is known as “Covered CALL”. I will explain more about this in part 2 of this article because it’s a lengthy post if I combine it here. So, I hope this adds value to you all.
Stay tuned for part 2 of this article! If you would like to learn more about options, we do have option course coming in April 2021 for a price of only RM299 per person. You can register your interest here – https://forms.gle/hzjNGGHjYvrHPHrM6
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DISCLAIMER: The above mentioned stock or derivatives is NOT a recommendation to buy or sell but merely for education purpose. You should do your own due diligence on the mentioned companies before making any investment decision. The author is not liable for your profit or losses made out of your decision to buy or sell.