Today, I want to share with you how you too can sell options for monthly income safely and simply.
First, what are options?
“An option is a contract agreement which gives the buyer the right to buy or sell stocks at an agreed-upon price. We call this agreed price Strike price.”
For simplicity, we are only talking about options on stocks here.
There are two types of options:
- Call option – it gives the option buyer the right to buy the stock at Strike price.
- Put option – it gives the option buyer the right to sell the stock at Strike price.
When you sell options, the options buyer pay you money(i.e. premiums).
As options seller, your responsibility is to buy/sell the stock at the agreed price(i.e. strike price) when the option is exercised by the option buyer.
Let me give you an analogy to help you understand better.
I assume that you buy travel insurance from insurance companies whenever you go overseas.
When you buy travel insurance every time before you fly, you pay premiums to the insurance company in exchange for protection.
In this case, the insurance company collects money from you upfront.
If nothing happens by the time you return, the insurance company gets to keep the money for free.
But, if something happens during your trip, the insurance company will give you the payout based on the insurance contract.
As option sellers, you are like the insurance company, selling protection to options buyers and collecting premiums upfront.
Is the insurance business a good business?
Yes, of course.
First, it gets consistent cash flow month after month.
Secondly, most of the time it gets to keep the money for free.
But, when something terrible does happen, the insurance company has to give you a large payout based on the signed contract.
So, that is the risk the insurance company is taking.
Similarly, there’s risk in selling options.
In fact, it’s very risky if you don’t know what you are doing, just like all other investments such as stocks, Forex or Futures.
But, the key difference between people who make money and those who don’t is that they know how to manage their risk.
If anyone tells you that their strategy is guaranteed to make you money 100% of the time, they are definitely NOT telling the truth.
Not a single strategy out there does that.
There will always be winning trades as well as losing trades.
But, as long as your total winnings exceed your losses, you are profitable overall.
That is what the insurance company does as well.
It ensures its profitability by managing its downside risks.
Now, I am going to show you how you can build your very own “insurance company” while managing your downside risks.
Here’s how you can do it.
First of all, you find Good Stocks to sell options on.
The key here is picking good stocks.
What are good stocks?
Do you think Apple is a good stock?
How about Coca Cola?
What about Kraft Heinz?
Even if you don’t know anything about fundamental analysis, you would still know that these companies are great companies that have been doing well for many many years.
Now, let say that Kraft Heinz is now trading at $78. And this price is a good price from a valuation point of view.
Would you mind owning a small part of this great business if you think this is a great company for the long term?
Chances are that you won’t mind.
So, what if I tell you that you can buy this stock at a discounted price?
That means buying the stock for much less than the current price $78.
My guess is that you would be more willing to buy at a lower price.
Everyone likes a good deal.
Selling PUT options does exactly that.
How does PUT option work?
When you sell a put option, you are agreeing to buy a stock at an agreed price (i.e. strike price) at a later date.
One option contract gives the PUT option buyer the right to sell 100 shares at strike price when the contract expires.
For example, you are selling one PUT option contract on Kraft Heinz with a strike price of $75 and expiration date that is one month from now.
That means you agree to buy 100 shares of Kraft Heinz at $75 one month from now, regardless whether the market price at that time will be higher or lower than $75.
Let say, the premium quoted for this PUT option is $0.30.
If you sell 10 option contracts, you will collect $300 as premiums upfront.
Here’s the simple calculation:
$0.30 x 100(shares) x 10(contracts) = $300
There are two different scenarios that will happen.
Scenario 1: Stock price is above the strike price of $75 at expiration
If the option is never exercised, you get to keep $300 in your pocket for free.
In the case that the PUT options are never exercised by the expiration date, you’ll sell PUT options to collect premiums again and again.
Our main objective is to get monthly cash flow from selling options instead of acquiring the underlying stocks.
When you buy a stock, you make money when you sell it at a higher price.
But, sometimes it might take a long time for the stock to reach your profit target.
Or you might be waiting for the price to come down a bit more before you decide to invest your money in the stock.
In the meantime, you just wait and get nothing out of it.
Your precious time is wasted.
And what if the stock price just keep going up before you manage to get in at a lower price?
You will miss on the big move and the profits it brings with it.
But, everything changes when you become an option seller.
You get paid upfront every month from selling options while waiting to buy a great stock at a discounted price.
Even if you don’t get to buy the stock, you still get the cash flow every month from your option premiums.
The only downside is that you will miss out on the profits if the stock price goes up substantially. But, no one can predict when and how much higher the stock can go. It could well start making the big move after many months or years.
Scenario 2: Stock price is below the strike price of $75 at expiration
If the stock price falls below $75, the options will be exercised.
In the case that the option gets exercised, you will buy these shares at $75.
So, what do you know next?
You sell covered CALL options to help you get out of the stock at your break-even price or better price for a profit.
If your CALL options are not exercised, you get paid to wait for the stock price to go back up while bringing down the cost price.
It’s a known fact that stock market will be going up over the long term.
Along the way, there will be market crashes.
But, it’s only temporary.
The stocks have always managed to bounce back and make new highs.
The recent 2008 market crash was a perfect example.
Even after the worse recession, the Great Depression, the stock market again bounced back and continue to go higher and higher.
So, it is just a matter of time that the stock will come back up again if you are investing in a good company.