What is a Put vs Call Option?
An options contract is a contract that allows the holder to buy or sell an underlying security at a given price, known as the strike price. The two most common types of options contracts are put and call options, which give the holder-buyer the right to sell or buy respectively, the underlying at the strike if the price of the underlying crosses the strike. Typically each options contract is written on 100 shares of the underlying
As stated, the main two types are put and call options and investopedia has a great break down of comparing the two basis of all option trades:
- Buying a Call – You have the right to buy a stock at a predetermined price.
- Selling a Call – You have an obligation to deliver the stock at a predetermined price to the option buyer.
- Buying a Put – You have the right to sell a stock at a predetermined price.
- Selling a Put – You have an obligation to buy the stock at a predetermined price if the buyer of the put option wants to sell it to you.
An Example of Selling a Put Option
We are going to follow a made up company with the ticker, ABC.
- On 6/1 ABC is trading at $50/share
- I sell a put option with a strike price of $40 with a strike date of 6/30
- I receive a premium for creating an obligation which is credited to my account as cash
After Time Expires – What are my possible outcomes?
- On 6/30 ABC is worth $60 – Nothing happens I keep the premium
- On 6/30 ABC is worth $40.00 – I am forced to buy the 100 shares at $40.00 ($4,000)
- On 6/30 ABC is worth $30.00. I am forced to buy the 100 shares at $40.00 ($4,000) yet I am holding a position only worth $3,000
The last possible outcome is where the risk comes into play when dealing with selling naked puts. Notwithstanding, I think my strategy directives below limit my risk to a comfortable level (even for me considering how just low my risk tolerance is).
My Selling Put Strategy to Increase Current Income and Returns with Dividend Growth Stocks
At the current time, I am not interested in trading options so I can leverage the amount of shares that I can control (remember 1 options contract = 100 shares), rather, what excites me about the strategy is the opportunity increase investment income with variables that can be controlled to lower/minimize risk. With my mission stated, I have come up with guidelines for myself that might change over time, but I think give me a good starting point.
I Will Only Buy Naked Puts on Those Stocks that Pass my Stock Screen
I originally believed that I would use my, my dividend growth stock screen as a way to find stocks, however, because of the safety built in with my trades the corresponding options weren’t that attractive. As such, I have created new screen for this level of my income building investment pyramid.
- The company needs to have a P/E less than 20; and
- The company needs to have at least a 2.5% yield; and
- The company has to have at least 5 years of dividend history; and
- The company has to have a payout ratio of under 50%
The Strike Price Will be a Price that Has only been hit a handful of Times on a Multi-Year Chart
It is my goal to collect the premium and not actually get stock put to me, so it would seem prudent to choose a price that has rarely been hit. I recently bought a few shares of Target, so lets use them as an example since we know it meets Directive #1. I am going to use the 3yr chart (you may have to zoom in):
There were only 3 times inside the past 3 years that Target dipped below $55 – $58, and as important, there was a bounce back within a year. So Directives #2 is that I am looking for those stocks left (from #1) that rarely dip to the strike price I’d be choosing and when it does there is a bounce back. So even if I am “put” a stock I have a fairly good feeling that at some point in the near future I can roll out (should I need to)…which leads me to Directive #3.
I Will Only Risk 50 to 75% of my Current Capital on Margin
This is a bolt-on strategy to increase returns/income, and as such, I can’t even imagine waking up to a margin call from broker where they are demanding me to fund my account with additional capital (versus having to, reluctantly, sell positions). What does this mean in real life? If my account is worth $10,000 and we use that Target example above I would be forced to buy 100 shares at $55 that would be $5,500 which is at the low end of what I am willing to risk.
I will Spread out the Expiration Date
In an effort to further minimize risk I am going to use multiple expiration dates instead of concentrating on one date. I think Directive #4 will allow me to avoid a broad market sell off and being put with multiple new positions. I think I am looking at a rolling 30 to 60 day option contracts.
All Premiums Received will be Reinvested the Following Month
My final directive is a way to make sure I focus on compounding. As stated a few times, this is an add on strategy so if my main strategy is to invest $500 a month then any additional money received will be added on to that purchase (as opposed to a substitute for new money going in).