When I talk or write about trading options on stocks, the most-frequent reaction I get is that they’re just too risky – that it’s just too easy to lose money with them.
That’s actually not true.
In fact, there’s a bigger risk in not trading options.
By avoiding this slice of the capital markets, investors are missing out on one of the best income opportunities available today.
In fact, one of the biggest investing secrets is that you can create “income on demand” simply by selling options contracts.
This is a strategy (a personal favorite of mine) that can deliver streams of “income” on a stock you own – and is something you can do over and over and over again. Consider it an income “kicker.”
I understand it can be tricky or feel daunting, so today I’m going to tell you about what I believe is the simplest – and safest – way to get started with options: Selling covered calls.
Options: The Cliffs Notes Version
The fact is that options trading is easier and less costly than ever before. The numbers prove this. In 2022, a whopping 10.3 billion U.S. options contracts were traded. That’s an all-time record, and is double the volume from just three years prior.￼ So clearly, a lot of savvy investors believe options are a great way to make extra money in the market.
As I see it, the genuine risk is the thousands or even millions of dollars in lost opportunity you face by NOT being in the game.
Let’s start by defining a couple of basic terms.
Options are contracts that give the contract’s buyer the right – but not the obligation – to buy or sell a specified number of shares of a stock at a specified price, before an expiration date.
A call option gives the buyer the right to buy that stock. A put option gives the buyer the right to sell that stock.
With both option types, you can take either end of the trade – meaning you can buy or sell them.
Whether you are selling a call or a put option, the goal is the same: You want the value of that contract – known as premium – to fall to zero. Your focus isn’t on the stock, but on the contract.
The Fine Art of the “Covered Call”
We’ll confine today’s discussion to an income strategy known as the “covered call.”
As I just described, each call option contract gives the buyer the right, but not the obligation, to buy 100 shares of the underlying stock at an agreed-upon price per share (called the “strike price”) by a certain date.
Since you’re selling the call, the buyer pays you for that right – a payment known as the “premium.”
If the stock stays below the strike price or if the buyer does not “exercise” the option to buy the stock, the option expires worthless and you, the seller, keep 100% of the premium.
But what if the opposite happens? What if the price of the stock climbs above your strike price and the buyer exercises his right to buy the stock? The worst thing that can happen here is that you sell your shares – 100 shares per contract – of the stock.
Let’s dive in with a little more detail.
Putting it into Practice
Here’s how to do it.
Suppose you own 100 shares of Netflix (NFLX). You’re looking for some added income to reduce your breakeven price on the stock, so you decide to sell a covered call.
You’ll automatically earn the premium or the price the buyer paid for the option to buy the underlying stock.
Your best-case outcome is when the contract expires worthless. You pocket the premium (ka-ching!) and you keep all the shares of your stock.
And, as described above, the worst-case scenario here is that the buyer executes the option and buys – or “calls away” – your Netflix shares.
Let me emphasize this point: The biggest risk here is limited to some potential opportunity loss. Since you already own shares (100 shares per option contract) you may miss out on some gains as the stock moves above your strike price, but you’ll still pocket the premium and hopefully bank a capital gain by selling the stock for more than you paid for it.
Pro tip: That is why it’s always a good idea to sell your covered calls at a price higher than what you paid for your shares to begin with. The worst-case scenario here is that you collected premium (which you get to keep no matter how the stock’s price moves) for selling the option contract and you sell your shares at a profit.
And in the spirit of “lather, rinse, repeat,” you can keep winning over and over again by selling covered calls against the stocks you own for as long as you like – provided the contract is never exercised.
If you’re new to options, I can’t emphasize enough that selling covered calls is the safest way to dip your toe in the water. But you should be absolutely certain that you have 100 shares of stock for each contract you sell. Selling a contract without owning shares is called selling a “naked call” and that can be incredibly risky.
I hope you found this helpful. Next week I’ll share two powerful secrets of winning options trades.