The most consistent options income available to the average investor is selling puts on stocks you want to own. There are fancier strategies out there for generating options income, but they all rely on more precise timing for both price direction and volatility, and more complex trade management. If you want to maximize your chance of success and generate consistent options income, keep it simple by selling option premium on good companies at reasonable prices.
Put Option Basics
If you’ve never dabbled with options before, a put option gives the buyer the right to sell 100 shares of a stock at a given strike price anytime before the options contract expires. Conversely, the seller is obligated to buy 100 shares of a stock at a given strike price anytime before the options contract expires.
You’ll often see the contracts written like this:
Let’s break it down:
- JNJ210917P145: JNJ is the ticker of the underlying company. In this case it’s Johnson & Johnson
- JNJ210917P145: 210917 is the date the contract expires, expressed in the [year][month][day] format. Read it as September 17, 2021.
- JNJ210917P145: P stands for put to let you know it’s a put contract (as opposed to “C” for call).
- JNJ210917P145: 145 is the strike price. It represents the price of the stock where you can buy or sell it depending on whether you’re long or short.
No matter the price of JNJ between when the put option was written and the maturity date of September 17, 2021, the buyer of the put option has the ability to sell 100 shares of JNJ to the writer of the put option. Even if the price of JNJ is $100 they can still sell it for $145 to the writer of the put option. That ability, or option (see why they’re called that now?), is why investors pay good money to buy them.
How are they priced?
You might have heard about the Black-Scholes equation. It’s a formula that was a pair of professors’ best guess as to how to accurately price an option. It takes into consideration the amount of time left until the expiration of the contract, the risk-free rate available, the distance of the stock price from the strike price, plus an estimate of the volatility of the stock’s price between now and expiration.
This formula was the starting point of modern options pricing models – since then the formulas have been tweaked and more accurate formulas are generally closely guarded as whoever has the most accurate options pricing model will generally stand to make the most money.
Why sell put options for consistent income?
Selling put options may seem complicated or more risky than just owning stock or selling covered calls, but it’s really not.
The reason that I prefer selling put options versus covered calls is due to skew. Skew is the tendency of put options to be priced more richly than call options due to the propensity of markets to have sharp sell-offs versus sharp spikes. And since sharp sell-offs that involve losing lots of money is more painful for investors, they’re willing to pay up a bit more for the insurance.
Your risk as someone who sells put options is the difference between the strike price less the premium received and zero. Since for normal stocks you’d want to do this on the annual premium is usually 10 percent or so, the most you can lose is 90 percent of your investment. Compared to holding the underlying stock and the most you can lose is 100 percent. The flip side is that if a stock goes up 20 percent then your gain is capped at the premium received (again, generally 10 percent).
So why go through the hassle of keeping track of selling premium when you’re capping your upside? The easiest way to explain it is through the example of buying a Tesla. Even though I’m always scratching my head over Tesla’s valuation, I do love their cars:
When’s the last time a Tesla Model S went on sale?
I don’t think they ever have because it’s an awesome car that’s in high demand. So the price stays high. But what if you could buy a brand new Tesla Model S for 10 percent off?
You’d totally buy it.
10 percent off a quality company: an example
Just like a Tesla Model S, quality stocks don’t go on sale all that often. Let’s use Johnson & Johnson as an example since I recently sold a put that expires on September 17, 2021 with a strike price of $145.
The chart above is from the oh-so-useful FastGraphs and shows Johnson & Johnson’s stock price versus a “Fair Value” multiple of 15x (orange line) and the normal trading multiple of 16.7x (blue line) for the time period selected. Given the consistency of the company’s earnings, its strong balance sheet, its dominant market position, and its consistently growing dividend, the stock price very seldom touches, let alone goes below, the “Fair Value” multiple.
But what if you don’t want to wait for one of the 3 times in the past 7 years that price kissed fair value?
Easy: apply your 10% off promo code to the stock price by selling a put that expires in one year with a strike price that is at or slightly below the current price. The current premium of the -JNJ210917P145 option as of October 6, 2020 is $14.15 so do the math:
$145 strike – $14.15 put option premium = $130.85
The fair value estimate using the normal trading multiple of 16.7x = $131.58. And that’s with the dip in 2020’s full-year estimated earnings. By selling the put option you’re ensuring your cost basis for JNJ is below fair value even though it’s still trading a bit more than 11 percent above what you want.
So one of two things will happen:
- Price stays at or above $145 until September 17, 2021; or
- Price is below $145 at September 17, 2021 and you have to buy 100 shares for every put option you sold.
In the first scenario you make a ~10 percent return for the year. Given estimated future equity returns and paltry bond returns, that’s not a bad deal.
In the second scenario you end up owning JNJ at a price that it usually bounces up from. And if you do get assigned, you can always turn your consistent option income from selling puts into consistent income from selling calls on JNJ until it gets called away. Either way, the money will consistently come in.