Introduction

Option income strategies can be used to increase the yield of an equity portfolio by generating a consistent stream of income and by allowing for discounted stock purchases. This post will cover which options strategies to use based on your primary goal, how to implement these strategies, best practices and exit strategies to maximize their effectiveness. Investors looking to generate a consistent income on their existing equity positions can sell Covered Calls while investors wishing to obtain stock at a discount from the current market price while generating income can use Cash Secured Puts. 

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Cash Secured Puts

A cash secured put is simply selling a put option while setting aside cash to buy the stock in the case of assignment. This is slightly different to selling a naked put option where the writer of the put option hopes that price does not decline. The cash secured put is primarily considered to be a stock acquisition strategy but can also be an income generating strategy. As this strategy involves receiving a premium for selling a put option, the investor can generate a consistent income with this strategy. Furthermore, the premium received from selling the option can be used to reduce the total cost buying the stock in the case of assignment. 

Consider the following example:

$XYZ is currently trading @ $100/share

Goal: To purchase $XYZ at $95/share with a target of $120

In the above example, $XYZ stock is acquired $2/share cheaper than entering a buy limit.

Strategy

The ideal outlook for this strategy is that the stock has a short-term retracement before continuing a longer-term rally. Investors should have a neutral/slightly bearish short-term view while having a bullish long-term view. If the strike price is not reached and there is no assignment, the investor will keep the premium received as an income. Cash Secured Puts can be rinsed and repeated each period to generate a consistent income. 

Covered Calls

A covered call is the most popular way of generating an income through options. There are two steps required for an investor to execute this strategy – owning a minimum of 100 shares of a stock and shorting (selling) an “out of the money” call option. The investor receives an immediate income from selling the call option.

Covered Calls and Cash Secured Puts can be combined to acquire stock at a lower price and selling it at a high price. Consider the following example:

The investor already owns 100 shares of stock $XYZ with a current market price of $100

Sell Sept 2019 $120 covered call @ $2

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Limitations

Combining both strategies provides a great way for investors to buy low (using cash secured puts) and sell high (using covered calls). This also generates an income while the investor waits for the trades to execute. However, there are limitations to this strategy:

• Patience is required, trades generally only execute at expiration
• Potentially miss out on some opportunities 
• Requires trading in 100 share increments

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Optimizing Covered Calls and Cash Secured Puts

Covered Calls

Expiration Selection - Selling shorter dated options (21-49 days) have a higher certainty of profit as there is less time for the stock to make a drastic move. On the other hand, selling longer dated options have less certainty of profit but receive more premium. It may be tempting to sell longer dated options to maximize income, but shorter dated options work best for income strategies for the following reasons:

• Earnings - Earnings announcements cause a rise in volatility which may work against the investor. Shorter dated options reduce this risk. If an investor sells 12 1-month calls during the year, only 25% of them will experience uncertainty due to earnings announcements. This is significantly more ideal than selling 4 3-month calls where all of them will experience earnings uncertainty. 
• Premium is not linear to time - While longer dated options do indeed receive more premium, the relationship between premium received and time is not linear. Selling multiple shorter dated options will receive more premium than selling longer dated options over the same period. 

Strike Selection - It is important to remember the goal of selling covered calls. Covered calls are generally used as an income strategy that can be rinsed and repeated once the call expires worthless, but they can also be used to sell the stock at a high price after a sharp rally. Aggressive strike prices (high delta) that are close to the current price will receive more premium, but there is a higher probability that this price is reached forcing the investor to sell the shares and not maximizing the full extent of the rally. Conservative strike prices (low delta) that are further away from the current price receive less premium, but also maximize the capital appreciation of the stock during a sharp rally. While it may be tempting to use aggressive strike prices that have a higher income, maximizing capital appreciation and selling the stock at a higher price should be prioritized as the gain received from capital appreciation is more than the gain received from using an aggressive strike price.

Cash Secured Puts

Strike Selection - Deciding on the strike price for Cash Secured Puts is a much easier task than for Covered Calls. This is because the primary goal for selling Cash Secured Puts is to obtain the stock at a discount while also receiving a premium. In this case, using aggressive strike prices is preferred. Aggressive strike prices that are close to the current price have a higher probability of being reached while also paying the investor a larger premium.

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Best Practices and Tips

• Acquire shares at a discount using Cash Secured Puts
• Start selling covered calls immediately after acquiring shares
• Use shorter dated options to maximize time decay
• Use aggressive strikes (high delta) for cash secured puts
• Use conservative strikes (low delta) for covered calls
• Avoid selling covered calls going into earnings announcements

Summary

Deciding which strategy to use is based on the primary goal of the investor. If the goal is to simply generate income from the existing stock in the portfolio, selling Covered Calls is the best strategy. However, if the goal is to obtain the stock at a cheaper price, Cash Secured Puts provide an ideal way of doing so. If the goal is to maximize capital appreciation, both of these strategies should be used together as it allows investors to “buy low and sell high”. No matter what the end goal is, following the best practices for each strategy mentioned above and having a consistent, methodological approach will allow you to maximize the effectiveness of each strategy and enhance the yield of your portfolio!

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