In order to understand this strategy you will need to fully understand what Puts and Calls are. If you need to learn about Puts, please read this article. If you need to learn about Calls, please read this article. Now that I have that out of the way, I will go ahead and dive into my favorite options trading strategy! This is the strategy I tend to use the most as it is conservative and it tends to yield reasonable results. This strategy consists of 3 steps. Check it out below!
Step 1: Sell a cash secured put for XYZ stock
This step consists of you, the trader, selling a cash secured Put to a buyer. A Put is cash secured if you have the cash to back up the trade should you be exercised and have to purchase 100 shares of that stock. You can select any stock that you feel comfortable trading as long as it is optionable. This means you must be able to sell options for that stock. When you sell the Put, you will receive a premium. If you are not exercised by the option’s expiration date, then you simply receive the premium and move on with your life. That is it. You just made money for selling something you do not own. Crazy right? If this happens, then the process ends here. You can continue to sell cash covered Puts until you are exercised.
Now, if you ARE exercised then you must purchase 100 shares (we are not considering Micro-options in this article) of the chosen stock at the strike price you sold the Put at. For example, let’s say you sold a Put with a strike price of $16 for XYZ stock whose current market value is $17. Let’s also say the expiration for this Put option is the end of the month. If by the end of the month XYZ stock is below $16, you must purchase 100 shares of that stock at $16. Now don’t freak out though. If you end up owning the 100 shares of XYZ, then you move on to step 2 of the strategy.
Step 2: Hold for Dividends
In this step, you will hold the shares of stock you own for dividends (assuming it pays any). I highly recommend selling Puts for companies that pay reasonable dividends. This is up to you however. During this step, you will simply hold the shares you own for the dividend they produce, and add that new income to the premium you already received. For example, if XYZ stock pays a dividend of $.18 a share per month, you are now making $18 a month for just holding the stock. It is possible to move on to step 3 as soon as you begin step 2, or you can sit on your little money maker for as long as you would like. The choice is yours. A majority of the time, I prefer to move on to step 3.
Step 3: Sell Covered Calls
This is where things start to get interesting. Now that you own the stock, you can sell a Covered Call. This means that you own the shares you are selling the call for. Your risk when you sell a Covered Call is simply the 100 shares you purchased in step 1. When you sell the Call, you will receive yet another premium. If the Call expires, then you simply collect your premium. This means that you will have, so far, received 2 premiums as well as your dividends. You will also still have the shares of XYZ stock. How cool is that?!? You will also be able to continue selling Covered Calls until you are exercised!
Now, if the Call is exercised, you must provide the buyer with your 100 shares. You will however, still receive a premium. You will also receive any difference between the value you paid for the stock and the value of the stock when the call is exercised. For example, if you purchased XYZ stock at $16 a share, and your call is exercised at $18 a share, you will receive the difference of $2 a share. This means that you will receive $200 because options are typically in 100 share increments.
By the end of this scenario, you will have received 2 premiums, your dividend ( assuming you held it long enough to receive one), and the difference between the value you paid for the stock and the value of the stock when the call was exercised. It is pretty incredible. I hope you see why I favor this strategy above all others. I am sure some of you will see the risks of the strategy such as the potential for the stock to not rise above what you paid when the put was exercised, but in the end I still believe it is worth it. When you simply purchase shares of a company, you are taking on the risk of the shares dropping in value anyway. I am sure you see where I am going with this. Feel free to ask any questions below, and please start a conversation or two! Want to learn more about stock market investing? Sign up for my email list to receive my free ebook, “Breaking Into The Stock Market”!