Questions on using options for income

I am looking into how best to use options to generate income. Are there any relatively low risk methods to do so? What are the considerations when doing this with a retirement portfolio?

How do you use it? Do you use it to supplement some of your income or to generate most of your income?

tj

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Hi @thejusticier,

If you have been reading the SA Options board this year, you should have noted the severe pain that some are have been experiencing this year by writing a lot of puts. With the market swoon, they are having stock currently valued at $80 and having to pay $400 for it when assigned! One poster was down 90% on his portfolio.

That is significant risk to me. Knowing the directionality of the market.

I use options as a small part of our portfolio. I don’t do puts since I do not want to tie up cash or use margin.

Normally I buy LEAPS. I also occasionally sell covered calls.

Moderation …

Does that help you?

Gene
All holdings and some statistics on my Fool profile page
https://community.fool.com/u/gdett2/activity (Click Expand)

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First thing that is VERY important to understand and to internalize is that options are truly a zero-sum game. For every penny that you gain on options, someone else loses on that option. So as far as risk goes, whoever is on the other side of your trade is swapping the risk for the price at the time you buy/sell the option. So, unless you think there are people out there that are so irrational that they are regularly willing to hand you “free” money in return for “low risk”, tread carefully.

That said, there are ways to use option combinations to select any risk you choose to select. Typically, a spread can be used to ratchet up or dow the risk. This is partly because for every option you buy, you sell and equal number of other options. So when the time value is going down on the one you purchased, it is also going down on the one you sold, maybe not equally, but at least in opposing directions to be closer to neutral.

For example, let’s say you think stock XYZ is going up, and that it will probably go up some time between now and June '23. XYZ is trading at 80 now, but you expect it to pop up above 100 at some point soon. You can select all sorts of spreads (“bull call spreads” let’s say, for short BCS). You can choose a very conservative Jun '23 70-80 spread, and perhaps pay $8 for it (buy the Jun '23 70 call, and sell the Jun '23 80 call). When the stock rises over the next few months, that $8 will turn into $8.50, and the into $9, and finally if the stock is near $100 in June, it will be worth about $10 (which is obviously the maximum it can ever be worth) and you can exit the trade with a $2 gain.

Now, you can be more adventurous and choose a much riskier trade, and naturally get a much higher expected return. You could instead choose to buy a 90-100 BCS, and perhaps pay $5 for it. In June, if the stock is trading at 100+, that spread will be worth $9.50 or so, and if it ends (3rd Friday in June when those options expire) above $100, the spread will be worth $10. That gives you a whopping $5 gain! And you can choose any spread you want, with varying risks from tiny tiny risk to huge huge risk. You can choose a 60-70 spread for a 50 cent potential gain, or a 60-100 for a very wide spread, or a 110-120 to get a massive gain (but with lower probability of it happening).

One especially good thing with these kinds of spreads is that your gain and your loss is limited on both ends. The most you can lose is what you put into the trade, and the most you can gain is the difference between the two strike prices minus what you paid initially. That is not true for many other options trades, for example, if you sell a call without owning the stock, you could have heavy losses (higher, even much higher, than what you put into the trade initially) of the stock rises quickly.

Some people regularly sell calls on stock they own, and adjust their risk to their liking. I think @captainccs discusses this periodically on various boards here.

I also sell puts periodically. Only on stocks that I want to buy, and usually for the purpose of either:

  • receiving a discount on the purchase price.
    or
  • keeping the put premium and never ending up buying the stock

If a stock is trading at 100, and I wouldn’t mind owning some more, I can buy the stock at 100, or I can sell a 105 put for $7. When the buyer of that option “puts” it to me, I pay $105, and subtract out the $7 I received for the put, and have a net purchase price of $98 (or 2% less than what I could have purchased it at the market price that day). Of course, something things happen, and the stock could suddenly rise a few bucks. If it rises above $105, let’s say to $108, no rational person would exercise that put option (because why sell a stock at $105 via an option when you can sell it at $108 in the market???) and if the option expires unexercised, I get to keep the $7 option premium premium that I received.

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I hear you. I have tried a hand at this and each time regretted it. the only way i use options now is that if I am interested in buying 100 shares of a company I use puts to bring my cost basis down or once I hit valuation on a holding that’s making me nervous I will sell a call. with latter i will do it only if I hold at least 200 shares so even I end up losing my shares I dont left out of further upside.
One other option strategy that jim gillies has mentioned on the morning show is called a synthetic long. he discussed in the morning show on 12/2/22 and couple other times before. Cheers.

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I have used a service for years - the Cabot Options which Jacob Mintz is over. He is very good…doc

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These statements are factually incorrect and they are inconsistent with the established theory and practice on how options are priced (valued).

Options as zero sum would be correct only if buying and selling stocks is zero sum. This is because buying and selling stocks is one way that options market makers (the trading desks of big Wall Street trading firms and investment banks) hedge their trading books.

As an example, I can buy a call from an option market maker and the following can occur. The market maker buys stock (at an amount based on the delta of the option) to hedge and is thus long stock and short the call sold to me, so the market maker does not have equity risk. For simplicity, we can assume that the call is deep in-the-money with a delta near 1, so the market maker is long 100 shares and short 1 deep in-the-money call netting zero equity market exposure. The price of the option includes an interest rate that encompasses the market maker’s cost to hold the stock (e.g., cost of funds, securities lending value, liquidity, etc) plus a spread. The market maker makes money on the spread regardless of how the stock price changes (the equity risk is hedged to zero, so there is no gain/loss from stock price movements).

If the stock goes up, then I make money on the long call, so both me and the market maker make money and there is no zero sum. If the stock goes down, then I lose money, and the market maker still makes the spread, which is not related to my equity loss, so there is no zero sum. These outcomes for me are no different than if I buy the stock outright, except when I buy a call option the market maker is financing part of the cost and charging me an interest rate (and the option has a time value component related to the stock’s volatility which I am buying but note that this volatility component is small if the call is deep in-the-money).

The theory of asset pricing explains why the above is possible and this theory is the basis for how options are priced/valued.

The above scenario is not fundamentally different from me borrowing money and buying assets, stock or otherwise, that provide some return on the funds invested.

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I said “options trades are zero sum”, and that is absolutely correct. And I know that “options+associated stock trades are not zero sum” because the “stock trade” part of it isn’t zero sum. But an options trade alone can only be zero sum because someone sells it and someone buys it, and later it either gets bought back by the seller, and sold by the buyer, or it gets exercised by the buyer against the seller.

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Hey TJ,
Options are not as scary and murky as people let on. I joined the MF options service for about two years to learn. It was a pricier product, but I have made way more than the entry fee on my own since then.
Options are just the same risk as going short on stocks, or trying to day trade. Some people can make it work, others just end up throwing money away. Everyone has to judge their own capabilities and what they are willing to risk.

Here’s how I have used my knowledge for the last few years.

  • Calls: These are positions where I have more than one hundred shares I already own. In rising markets I used these very sparingly, but in stagnant or volatile markets (like the last two years) I can make good returns. I am playing on the volatility, and even if the stocks do get called away, the volatility of the market gives me other chances.
  • Puts: These are for stocks I already own, but I could feel comfortable owning more. The big thing with puts is that you cannot cry if the stock price goes up super fast and you never owned the stock ('cause you only get the premium). I do put options when the market has nowhere else for my money. IE - things just too dang pricey and I don’t want that price, or on flip side is I am full up on most position allocations so not really looking to boost my exposure across most of my portfolio. A put for me has to also have good call side activity, meaning I pretty much always flip to call on any put I am assigned.

I just closed a DDOG call today for .01, which means I got 97% of the premium still. I have calls on NET, S, ETSY, UPST going this week.

(For UPST, this is a way to lower my cost basis on a stock that is WAYYYYYYY down, but one I really think has a future. Even if they do get called away, there is going to be time to buy back in…do not give into FOMO.)

The biggest caution I would give on Options is that they require attention. Not like holding a stock and walking away. About that DDOG option I just closed: days after I opened it was looking like I would lose the shares, last two days market volatility went in my favor, so I closed it. This takes time to learn your stocks, and to just stare at your tickers until you want to close out an option.

Other than that, it is a great way to add about 2-3% income to your overall portfolio in times when the stocks themselves are just sitting there. (YMMV)

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Luckily there’s a ready supply of people out there willing to give you 2-3% in return for “nothing”!

That’s a little sarcastic, and it isn’t really true, because you are trading the acceptance of certain risks in return for that 2-3%. However, research has indeed shown that option sellers (writers) are more sophisticated than option buyers and thus do better overall.

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Another thing to consider is that you will pay taxes on the profit. Also, if this is a covered call you will pay taxes on the stock profit (capital gains) if it gets called out. All that being said, there are some sites for looking for options like :
www.optionsdash.com

I used to pay for the covered calls site and made quite a bit of cash doing buy/writes. The optiondash site is very good and I use the free version. Just create an account. HTH…doc

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All of my options are in a Roth IRA, so no tax consequences of any assigned options or option premiums.

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I do options in my pension plans, but the original poster may not be doing this like you and I…doc

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Well, I think I understand what you are saying, but taking an equity option contract and viewing it in isolation from its underlying stock market is a pretty narrow statement for understanding options, and more specifically, a narrow statement for understanding options pricing/valuation and options markets.

This zero-sum perspective, taken in isolation, explains almost nothing about the actual economics of options markets, and I’m probably being charitable in using the qualifying word “almost”.

Options, as derivatives, derive their value from the underlying stock markets. It’s a very incomplete description to separate the option leg from the stock leg such as in the trade I presented above: one leg only exists together with the other leg for the options dealer (market maker). These kinds of trades are the foundation for options pricing and options markets.

As in my example above, options dealers aim to take zero equity risk and are in the lending business by earning the interest rates that are included in the price of options contracts. They also make money in other ways, such as on the bid-ask spread and by facilitating securities lending when they are long stock. They make money regardless of the movements of the underlying stock and resulting moneyness of options contracts.

I agree, taken in isolation, yes, an option contract by itself and separated from the associated stock market, is zero sum. But that’s really a trivial statement that doesn’t reflect how options are actually priced and valued, which is what actually matters for trading options. Options pricing and options markets are very specifically linked and dependent on their underlying stock markets.

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Quick follow up here, as I am changing my strategy just a bit.

The market seems to be showing more overall bullishness on techs in the last few weeks. The Fed is also making less waves in the market for now.

I am mostly sitting the last couple of weeks out of short term options as I do not want to fight any run ups that might call away stocks I believe in.

To each their own.

That is EXACTLY what I’m doing right now as well.

We’re very close to earnings (Jan25) on Tesla. Ignoring the noise, Tesla is seeing big increases in interest at Chinese stores with the price cuts and have signaled some big news for Investor Day on March 1st. So I’m NOT selling calls at this time on TSLA. Could I sell some calls on Thursday? Maybe. But it isn’t worth picking up a couple bucks premium and miss out on a more significant move. For example, TSLA is up about $6.50 (5.5%) today and would be pretty close to taking out any sold call position I might have done.

My other major positions have infrequent option availability and it isn’t worth missing out on a move with them either.

I still have my UPST puts expiring Friday… I would have done better just buying the shares. I’ll give that some thought.

Rob
He is no fool who gives what he cannot keep to gain what he cannot lose.

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