How to use options to generate consistent income
If you want to produce income from options, you need to be selling them. You can either be selling puts, calls, or a combination of either or both. Now we all understand what options are, how they work and how to trade them, it’s time to run through some strategies and techniques to show you how you can use them to generate yourself a consistent income.
Firstly let’s look at selling Puts. As you now know you will be paid structurally more for selling puts than calls (because of Skew), so Puts are likely to be your main income generators. In addition, to be selling calls you really need to own the underlying stock (unless you want to sell naked which is hugely risky- see earlier section) and that takes more capital.
Quick reminder, when you are selling puts- you are agreeing to (possibly) buy stock at a future date, for less than it’s trading today. To decide which puts to sell, there are a number of decisions you need to make:
1. Which stock are you going to sell puts on
2. What strike price are you going to choose
3. What expiry date are you going to choose
4. How many contracts are you going to sell
Let’s take each in turn:
1. Which stock are you going to sell puts on
There is a very simple answer to this question- only sell puts on a stock you are happy to buy and own. You can write put options consistently, and you can do so for a long time without ever being put the stock, but at some point you will be- this is almost an inevitability over time. You only want to be forced to buy something you actually like and want to own.
So don’t go around selling puts on a stock just because the vol is really high and you get paid well, because if the stock crashes and you get exercised, you’ll be owning it.
By only selling puts on stocks you actually want to own, there really is pretty limited downside for you in the long term. After all, if you like a company and believe it will do well, then you’re going to want to own it at some point. If that same stock is one you’re writing puts on, then you may occasionally be buying it via those same options.
And the benefit is that via puts you’ll be buying it at a lower price than you would have otherwise done if you’d just have bought if in the market, and you’ll have been paid to do so.
There are a couple of other things to consider:
1. There are some stocks and even entire sectors on which you shouldn’t ever be writing puts.
I would suggest that you should always avoid writing puts on stocks or sectors where underlying company values can and often are impaired significantly in a short space of time, by things you cannot predict. Think companies exposed to volatile commodity prices, with pending legislation, involved in M&A speculation, with highly volatile or insecure revenue streams, highly dependent on regulators etc. If there are significant valuation risks out there that mean you cannot reliably understand your downside risk, then you can’t know if you’re being paid sufficiently in premium for taking that downside risk.
2. Your reward (premium) for selling puts on a stock will vary over time both on an individual level, as well as overall across all stocks
The amount you receive in premium will depend mostly on the underlying vol level. Vol levels vary over time for both stocks individually, and for the market overall. As a result, the amount you get paid for accepting downside risk will vary over time- sometimes you’ll be paid a lot, sometimes the premium on offer may be insufficient. There will be some times (when vol is very low) when stocks that normally offer reasonable risk/ returns, simply don’t make sense in terms of real risk/ reward. This situation can persist for months at a time.
Always think intuitively about how much premium you stand to receive from your put sale, compared to the amount of capital you are risking in agreeing to buy stock. For example, if you stand to receive $80 in premium per contract but your puts commit you to buy $20,000 of stock, you’re receiving a pretty meagre amount in premium given the amount of capital you’re putting at risk (just 0.4%). If there’s a market shock (which will happen occasionally, and you won’t be able to predict when) then you could quickly find yourself underwater.
Think about premium as a percentage of your total exposure and this will give a useful guide for how attractive or not an option is. I would suggest that if you’re seeing less than 1% per month on offer, you’re probably not being paid enough to accept downside risk.
While single stock vol varies from time to time, there are also periods where put options across the board will be less attractive than normal. You will find that there will be periods (often a number of months) where overall vol is high and option premiums are rich (great for your income) and you’ll also see periods where overall vol and premiums are low.
Option income is not a precise science and it is not an exact consistent income- you need to accept that there will be good months and less good months and ensure your portfolio risk level stays consistent- don’t be tempted to ‘chase’ premium by taking extra risk just because you want to hit a certain income target.
2. What strike price are you going to choose
This is a pretty simple trade off and the answer is based on your personal and portfolio risk appetite- the closer to the money your strike price is, the higher the premium you’ll receive, but also the higher the likelihood your puts will be exercised and you’ll end up buying the stock.
If you really like it and want to buy it anyway- go for it and sell at the money or even in the money if it makes sense, but if you’re looking to generate consistent income, it can slow you down somewhat if you keep getting put stock each month as that uses up capital within your account, which reduces the number of puts you can sell the following month.
Each stock will vary, but as a rule of thumb you will likely find that around 10-20% out of the money is a good place to be most of the time. Much closer than 10% and you’ll find you continually get put stock (which may be okay but is not hugely capital efficient for income production), much further out than 20% and you’ll find your premium is so small compared to your risk capital it’s not worth bothering.
3. What expiry date are you going to choose
Most options expire on the third Friday of each month. Some more liquid stocks have weekly options available (expiring every week). By all means look at these, but you’ll typically find more liquidity and market depth in the normal monthlies.
For income production, you will want to keep your expiries reasonably short term- I would suggest 1-3 months. Typically, you’ll generate more income premium writing three 1 month puts, than one 3 month put. It also reduces your risk, in that your exposure rolls off after each month. If you’re in a falling market, this can be very helpful as options expiring each month will a) have less chance of being exercised and b) allow you to reset your strike price lower next month.
Something to bear in mind when thinking about expiry dates is the term structure. The term structure is a phrase used to describe how premiums vary for the same strike price across different expiry dates.
Typically you will see that longer expiries have higher option prices (for the same strike), and the increase is usually fairly linear. But the term structure can have lumps and bumps in it- certain expiries may have premiums significantly higher or lower than others. For example, if an expiry date crosses an earnings announcement, then you can expect that option to be more expensive, because volatility is likely to be higher. Good for us selling options, but also a greater likelihood of a large move and our options being exercised.
This is something to keep in mind, and something that is worth checking- if you see you’re getting paid proportionately more for a 2month potion than a 3 month option, it’s worth understanding why. You may be comfortable taking that additional risk, you may not- but you want to make that decision constantly.
In less liquid options, you may also see unusual pricing for different expiries simply because of market action- if there is a huge amount of activity at one particular expiry (sometimes it can just be one large buyer or seller), you may see prices moving in one direction and one expiry offering better (or worse) pricing proportionally than another. Remember the options market is not liquid and is not priced rationally or efficiently- these situations can be useful for you if you can spot them.
4. How many contracts are you going to sell
Simple answer- only sell contracts that represent an amount of stock you’d actually be willing to purchase. If your broker is offering you a load of margin and you can go out and write puts on $20,000 worth of stock, that might mean a bumper pay day in premium income, but if you’re continually writing puts sooner or later your options will be exercised and you’ll end up buying that much stock.
If your normal portfolio position size is $5,000, then buying $20,000 of one name might be riskier than you would like. So stick to your normal position size- and be consistent. You want to be able to keep selling options consistently for a long time, you don’t want to blow up in 3 months because you got greedy on income.
Also, you don’t want to have positions and then go through life stressing about them and having to check prices every day. You want to take positions that you are comfortable with, so you can go about the rest of your day and enjoy yourself without worrying.
It can help to spread your risk across expiry dates and across strike prices- for example rather than selling 3 contracts of the $100 March puts, perhaps you want to sell one each of the $90, $100 and $110, perhaps with expiries ranging from Feb- April. Check the prices individually (remember point 3 in this chapter) but if they’re fairly logical then spreading your exposure across a few strikes can be helpful. It makes it a little harder to manage your portfolio the more positions are in it, but it can pay off if you end up only being exercised on one contract, versus three.
5. How do you know if the price you can sell at is a good price
This is quite a personal determination. As you know, the price (premium) you receive for the option will be proportional to the likelihood of that option being exercisable (in the money at expiry). Higher vol = higher premium, strike close to current price = higher premium, longer term = higher premium.
As a guide, look at the premium you’re receiving vs the amount of capital you’re risking. A simple and quick way to do this is to look at the premium per share as a % of the current share price- that effectively gives you the ‘yield’ of your option (think of it in similar way to a dividend yield). You can do this on option price (per share contract) vs share price, or option total value (option price x multiplier) vs the notional contract amount (strike price x multiplier).
As a general rule of thumb, I’d say that if it is less than 1% per month, it might not be worth taking the risk. At that level you will be achieving 12%+ per year, which is very achievable consistently without taking enormous risk. Going lower will be lower risk, but remember that may mean you’re not really being compensated for the market crash risk that you are still facing. Often you’ll find stocks that will give you yields of 5% or more a month, and these are rich pickings that may not last forever, so take advantage when they’re available.
Personally I have around 10-15 stock that I regularly trade options on. These are all companies I know well and would happily buy at lower prices. On any single month I will likely have positions against 5-10 of those stocks. Remember that you’re only going to be trading options on companies and stocks that you actually want to buy if they fall in price, and this will naturally narrow your available possibilities- it’s not possible to know 100 stocks in sufficient detail to know if you want to own them or not. Research a small number of high quality companies that you are comfortable with, and use those as your base to create income.
By having 10-15 on the list, that gives you plenty of opportunities each month to find attractive premiums without having to spend all your time researching. Remember, it may be the case that individual stocks remain unattractive for options trading for quite some time, either because they are so overpriced that even a 20% decline doesn’t make them attractive or so attractively priced in absolute terms that it’s better to just buy them and hold them.
Conversely, there may be incredibly attractive periods for individual stocks- I have had some months where I’ve had all my option positions against just two or three stocks. Some people will suggest this is risky, but remember that the predominant risk in short puts is a real market crash, in which case everything tends to sell off together- so diversification won’t save you. It is better to concentrate in only those companies you would actually be happy buying, if the worst were to occur.