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So far, I have been talking about how good selling options are to earn monthly passive income. But, we all know any type of investing comes with risk. Selling options also comes with its own risk.
Today, we are going to take a look at all the hidden risks associated with options selling.
How Options Selling Really Works
Before that, let’s briefly revisit how options selling really works.
There are two types of options:
- Call Options – it gives the option buyer the right to buy the stock at an agreed fixed price at an agreed date in the future.
- Put Options – it gives the option buyer the right to sell the stock at an agreed fixed price at an agreed date in the future.
When you sell options, the options buyer pays you money(i.e. premiums) upfront.
If the option expires worthless by the expiration date, you keep the money for free. However, if the option is exercised by the option buyer, you will have the obligation to buy/sell the stocks at the agreed price.
Let’s look at an example.
A stock option contract is an option to buy/sell 100 shares of the underlying stock.
Today is 11th Oct 2017. Let’s say the 20 Oct 17 $155 PUT for Apple Inc. is worth $1.25.
If you sell 1 PUT option, you will get paid $1.25 x 100 = $125
Now, you have $125 in your pocket.
There are two possible scenarios:
Scenario 1: The market price of Apple Inc rises above $155 on 20 Oct 17.
In this case, the option expires worthless.
Why?
The option contract gives the option buyer the right to sell Apple Inc. at $155 per share. But, the option buyer can easily get a better selling price in the stock market since the market price is above $155.
There’s no point for the option buyer to exercise the option.
Results: You keep the option premiums for free.
Scenario 2: The market price of Apple Inc. falls below $155 on 20 Oct 17.
In this case, the option buyer will exercise the option.
Why?
Because the option buyer can sell Apple shares at $155 per share while the market price for Apple is below $155.
In other words, the option buyer gets a better selling price by exercising the option contract.
When the option is exercised, you will have the obligation to buy Apple shares at $155 per share even though the market price at that time is less than $155 per share.
What Are The Hidden Risks Of Selling Options For Monthly Income?
So, what are the hidden risks of selling options for monthly income?
Possible Risk #1: The stock price goes down to zero
When you sell PUT options, you have the obligation to buy back the stocks at the agreed price when the option buyer exercises the option.
Let’s continue with the Apple Inc. example above.
You sold one on 11 Oct 17 $155 PUT option for Apple Inc., and you got paid $1.25 x 100 = $125.
9 days later on 20th Oct 17, the Apple share price dropped to zero.
The option buyer exercised the option.
That means you had to buy 100 Apple shares at $155 per share even though the market price for Apple has dropped to zero.
This is the worst kind of scenario for selling the PUT option.
The stock price will only fall to zero when the underlying company goes bankrupt.
Here’s the good news.
There are always warning signs that you can look out for when the underlying company is in trouble.>
For example, their earnings fall short of expectations or they are unable to meet their debt obligations.
Companies hardly just go bankrupt all of a sudden without any warning signs.
Possible Risk #2: The stock price keeps going down
What if the stock price just keeps going down?
Let’s use the same Apple Inc. example.
You sold one on 11 Oct 17 $155 PUT option for Apple Inc., and you got paid $1.25 x 100 = $125.
9 days later on 20th Oct 17, the Apple share price dropped to $150.
The option buyer exercised the option, and you had to buy the Apple shares at $155 even though the market price at that time is $150.
So, you are holding 100 Apple shares with a cost price of $155-$1.25 = $153.75.
Here, you use your option premiums to offset your cost price to lower your break-even price.
If the Apple share price goes up to $153.75, you will be able to break even.
But, what if the Apple stock price keeps going down?
If the Apple stock price keeps going down, one way to salvage the trade is to sell covered CALL options.
With the premiums collected from selling covered CALL options, you are able to lower your break-even price further.
Will the stock price never go back up again?
Unlikely.
Why?
First, the stock market goes up and down.
But, it generally goes up over time.
After the 2008 financial crisis, the stock market recovered quickly and is now making new highs.
Similarly, the stock market rebounded after the great depression in the 1930s.
From the chart, you can see that the stock market has an upward bias and always goes up over time.
So, if you choose a company that has good fundamentals to sell options on, chances are that the share price will eventually rebound and you will be able to get out of the trade even with a decent profit.
Recommended Resources To Help You Sell Options Profitably:
Motley Fool Options service is NOT for options traders who are looking to frequently buy and sell options for short-term profits.
Rather, it’s for investors who are looking to use options as a tool to increase their investment returns on stocks that they want to hold for the long term.
Personally, I have been selling put options on my favorite long-term stock holdings for a long time.
For me, it’s more of a way to further reduce the cost basis of my stocks rather than generate income.
As for LEAPS, I am also using this options strategy on some of my favorite growth stocks to free up more of my capital and at the same time increase my returns.
But, I don’t use LEAPS on my dividend stocks because I still want to earn dividends from them.
That’s why I recommend Motley Fool Options if you are a long-term investor.
Because it’s really a great (but little-known) way to help you exponentially grow your investment portfolio without increasing your risk.
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