In a related article I discussed my three favorite options selling strategies for relatively conservative investors: covered calls, cash-secured puts, and bull put spreads. These can be used quite effectively in your online taxable portfolio, or in a Roth or Simple IRA account with options authorization. What’s very powerful over time is how these stock option strategies can be combined, even if you don’t start with a great deal of funds in your investment account.
So if I start by adding funds to my account, and slowly purchase shares in my favorite stocks over time, eventually when I have at least 100 shares I can sell a covered call. If it has taken me some time to accumulate that position, I might not be eager to just obligate it to someone else for what I paid, but let’s take a look at an example.
FOR EXAMPLE: Let’s say it’s taken me six months to build up a 100-share position in General Electric (ticker: GE) and my cost basis is $15.40 or $1540 (minus fees) in November. By the way, GE currently pays a .15 per share dividend in December, February, June, and September. To add to my dividend income, perhaps I decide to sell a February $16 covered call for $72. If GE crosses $16 by third week of February, it will leave my account and I will get $1600 plus the $72 options premium (minus fees), plus at least one dividend payment of $15, perhaps two equalling $30. If the stock drops in price, stays flat, or stays below $16, you keep the $72 premium plus the two dividends. Perhaps all the while you are accumulating more shares toward another hundred. Why would I let my GE position go away if it has taken me so long to accumulate? Because your initial $1540 cost to a $1672 return is an over 8.5% return in 4 months. And if you were planning on just holding the stock anyways, the $72 premium will be like a “bonus dividend”.
DOWNSIDE: If the stock drops a lot, the small premium, and the dividends aren’t much of a buffer to your loss, but if it’s a company you want to own, you don’t care if it gets cheaper -- perhaps you’ll buy more. Obviously, I try to only do this with stocks I really want to own.
COMBINING OPTIONS SELLING STRATEGIES
So in the example above, my wonderful stock is “called” away from me for $16 a share, which means it’s obviously higher than that in February. What can I do, I liked my GE position? First, I could just buy it back with my $1672 plus dividend(s) and start again, or I could just sell a cash-secured put.
So now I could go out a few months, February to April or May, and sell a cash-secured put. This obligates me to buy it if it drops below a certain price. The prices are fluid based on market volatility, but let’s assume for example that in February we can sell a $16 put for May for $99 with the stock at $16.35. We get paid to wait, and if GE drops back below $16, we must buy it, but our cost will be $1600 minus $99 premium (plus fees). We may likely miss a dividend payment, but if GE stays flat or goes up, we will keep the $99 put premium. We could continue this put-selling strategy until we are back in the stock, and then reassess to sell covered calls again. In a tax-deferred account like a simple IRA, roth, or rollover IRA, these gains won’t matter for tax purposes.
A bit more complicated strategy would give you more protection. To add another layer to the cash secured put you could sell a “bull put spread” in GE by selling a 16 put for $99 and buying a $13 put for $45, for example. The most you could make is the difference between what you took in versus what you spent ($99 - $45 = $54 before fees), but your risk on the stock is only down to $13 a share. If your stock plummets in three months, someone else is obligated below your level of obligation. For buyers of stocks that are sliding, this might make more sense than to accept having the stock put to them. Otherwise you can re-sell the put below that may have gained value on the way down, and still accept the stock. Once you have it, and it recovers a bit, you might decide to begin selling covered calls again. All the while you are collecting dividends and perhaps accumulating more shares.
PLANNING FOR LARGER POSITIONS
When you have enough shares to do this in blocks this can be even more effective. If you plan for this eventuality, you will have an effective longer term strategy for growing your investments. If you have 200 shares or 500 shares you could write covered calls on the whole block to reduce transaction costs -- or you could stagger your calls to different strike prices and/or months. For example, perhaps you write some at $16 and some at $17, so you always have an underlying position unless it moves considerably higher by expiration. What you might find is that you have combinations of covered calls and cash-secured puts on the same stocks for the same expiration months. You could make money selling calls and puts throughout the year, as some retail investors do. If this is done thoughtfully, and conservatively it can really increase the value of your accounts over time.
As always, only make trades or investments that you fully understand. Make sure you understand the basics of these three options selling strategies before you begin, and it's OK to paper trade before you do anything with real money. There are many places to continue refining your options education online and at workshops, seminars, and with courses (books and DVDs). And also make sure you consult with your tax professional, accountant/CPA, and financial advisors before committing any of your risk capital.
A NOTE ABOUT MY DIVERSIFICATION
I do strongly believe that I must not hold all my investments in only a few concentrated assets. For me, diversification is a matter of tracking all of our household investments and understanding at that level what we hold. On one single combined list all my holdings, those of my spouse, and those we hold together, we have tallied a spreadsheet that shows all our funds, stocks, and cash equivalents (savings). For us, having individual stocks adds more diversification, instead of reducing it. We know by investigating online that with all of our growth and tech funds through our job 401k’s and elsewhere that we have a great deal of exposure to Apple (ticker: AAPL), a company we both love. So when we wanted to add individual stocks we looked at consumer stocks like Kellogg (K) and Kraft Foods (KFT), which both pay dividends, which Apple doesn’t (yet!). Long-term risk for our individual companies, their sectors, market capitalization (size!), the overall market conditions, and exposure to developed, emerging, and frontier markets are things we look at! If that seems like too much, ask yourself this basic question: will this company/product/stock likely EXIST in twenty-five or more years? General Electric (ticker: GE), I think... yes. For example, consider the recent social media IPO stock LinkedIN (ticker: LNKD) -- will it be around in 25 years? -- I’m not so sure.