Today I'd like to introduce you to the wonderful world of options, and show you how I've been using them to generate tens of thousands of dollars of income over the last almost 10 years.
Below you'll read about a real trade I'm going to make — later this week, when the Motley Fool's strict trading rules allow — in my own personal portfolio.
After I make the trade, my broker will immediately deposit $780 into my brokerage account. That money is mine to keep, no matter what.
Of course, as with anything, there are risks. There's no such thing as a free lunch when it comes to investing.
Options are not for everyone, including Motley Fool Share Advisor's Scott Phillips.
Scott likes to keep things simple — recommending, buying and holding high quality ASX stocks trading at good prices.
But even Scott has promised to hear me out — and it's fair to say he's interested…
Before I go on, I must warn you that the options I use are exclusively on U.S. shares and the U.S. exchanges. Over there, as opposed to the ASX, options are traded on literally thousands of stocks, liquidity is generally very good, and spreads (the difference between the bid and offer price) tight.
As my broker, I use Interactive Brokers, but OptionsXpress is also an option. You can open accounts with both brokers from here in Australia. (Neither The Motley Fool Australia nor myself has an affiliation with either company, although I am a shareholder in Interactive Brokers (NYSE: IBKR).)
The trading commissions through Interactive Brokers — as low as $6 for ASX shares and $1 for U.S. shares — put the popular Australian brokers to shame.
Options Made Simple — Selling Put Options
The steadiest, simplest income and stock strategy is to write (or "sell to open") put options. This is how I started using options almost 10 years ago, and it remains the option strategy I use most today.
Don't be put off by the jargon — here's how it works:
When you "sell a put option", you are agreeing to buy a stock cheaper if it declines to your buy price, or lower, by the expiration of your option. You're paid for the option you sell, and no matter what, you keep that money.
Why are you paid to sell these options? Because you're selling someone an insurance policy. By selling a put option, you're telling someone, "If your stock falls below $48 by January 2015 (for example), I'll buy it from you at $48."
They pay you an up-front premium for that insurance.
Let's use a real-life example. Here's a trade I'm going to make later this week in my own personal portfolio…
Sell to Open Puts on CarMax
CarMax (NYSE: KMX) is a US-quoted stock recommendation in our Motley Fool Share Advisor stock tipping service. In US dollar terms, the shares are up around 12% since we tapped it for subscribers back in April last year, lagging a strong market.
I've already used options to generate good income on CarMax, and am going back to the well to do so again.
CarMax sells late-model used cars in more than 100 locations in 30 US states, with no-haggle pricing and salespeople on fixed commission. With a market capitalisation of US$11 billion, this is a solid company. At $50.57, the shares trade around 20 times forward earnings — neither cheap, nor overly expensive.
To potentially buy the shares even cheaper, you could write put options today, get paid while you wait, and set up a lower net potential buy price. Today, you could:
- "Sell to open" January 17th 2015 $48 puts. (In plain English, you're promising to buy CarMax shares on or before January 17, 2015 for $48 each, if the buyer of your option wants you to.)
- You should sell one put option for every $4,800 in CarMax shares you can afford to potentially buy (each option represents 100 shares of a stock).
- Collect around $2.60 per share. Each January 17th 2015 $48 put option recently pays you $260 per contract (a contract is for 100 shares).
So you're agreeing to buy CarMax at $48 if the stock falls to that price or lower by the time your options expire on January 17th 2015.
Options are rarely exercised before expiration, but they can be. For this agreement, you're being paid $2.60 per share. On your potential $48 purchase price, that equates to a 5.4% yield ($2.60/$48) in about five months.
That's a decent yield for this potential obligation. Annualised, the yield is close to 13%, although I'm always wary of annualising for fear of being greedy. As with any investment strategy, if you get too greedy, one day you will come a cropper. That's not a hypothetical… I've seen it happen.
Here are the possible outcomes:
- CarMax's stock is higher than $48 at expiration: Your put options expire. You keep the $2.60 per share, earning a 5.4% yield in just more than five months. It's income! You have no further obligation. Happy days.
- CarMax's stock is at $48 or lower at expiration: You can buy to close your puts and end your obligation before expiration if you like, earning a profit if you can buy your put options back for less than you were paid. If you keep them open, you're obligated to buy CarMax at $48. But you still keep the $2.60 you were paid, so your net buying price is $45.40; that's 10% below today's share price of around $50.57 Nice!
The trade I'm going to make later this week…
Later this week, when the Fool's trading rules allow, I will make the trade above in my own personal portfolio.
I'm going to write, or "sell to open," three January 17th 2015 $48 put options, meaning I'm potentially on the hook for buying $14,400 (300 shares * $48) worth of CarMax shares.
As soon as I make the trade, my broker will immediately deposit $780 ($260 * 3 = $780) into my brokerage account. No matter what happens, that money is mine to keep.
Wish me luck. I'll keep you posted on progress.
In the simplest terms, selling puts is an income strategy that lets you buy stocks cheaper if they decline. When they don't decline, it results in income again and again. Income-oriented investors look to write puts each month on safe, strong companies.
Used Foolishly, options are a powerful, logical and sensible tool, and they can become a highly profitable part of your investing life, making you a better investor in the process.
