In a recent article, I showed how billionaire investors like Warren Buffett use simple options strategies to generate millions in extra income.
And while not every investor can make a cool million or two using this simple strategy, it is possible to generate a nice bit of extra income -- and with very little risk.
For more on options trading and income, I'm turning to Amber Hestla-Barnhart, options strategist at ProfitableTrading.com, a StreetAuthority sister site.
(Note: To receive a free report from Amber that addresses some of the most commonly asked questions about generating income with options, click here.)
Bob: What was Buffett trying to gain from his options strategy? [See: "The Difference Between Warren Buffett and You"]
Amber: Buffett seems to want two things in life -- high levels of cash flow and value-priced stocks. He did the math on Coca-Cola (NYSE: KO) and saw that it was close to a price he was willing to pay. Most investors will simply buy when price are "close enough" to what they want to pay, but most people don't get the kind of results Buffett does. He never loses his head in the market, and Buffett has written in his annual reports that he never pays even a penny more than he thinks a stock is worth. Selling puts lets you set the exact price that you will pay, as you noted in the example above.
Selling puts also generates income. I target 1% or 2% a month as the minimum on my trades, although I often find trades that deliver two or three times as much income. Even with billions of dollars at his disposal, Buffett probably has more ideas than money at times. In this example, Buffett generated $7.5 million in income by selling puts and was able to put that amount into other investments. Knowing his track record, that money could be worth more than $100 million by now since his average gains are nearly 20% a year.
Selling puts allows us to share Buffett's goals and avoid overpaying for stocks we want to buy while increasing current income.
Bob: How can investors reduce the risks associated with selling options?
Amber: The best way to reduce risk is to only sell puts on solid companies you want to own. If you follow this one rule, you're ahead of 99% of options traders.
When you sell a put on a solid performer, you're basically betting that a great company won't fall to fire-sale prices in a short period of time. You receive instant income (known as a premium, as you explain above) from the buyer of the option in return. If the shares remain above what you determine is your dirt-cheap level, you'll keep the premium as 100% profit and never buy one share.
Once in a while, however, you may have to buy the shares. But that's not necessarily a bad thing -- after all, you'll be getting a great deal on a stock you'd want to own anyway. The premium you received when you sold the put lowers your cost basis even further. Plus, as you get more comfortable with options, you can then turn around and collect even more income from the stock using a different options strategy.
Bob: What types of stocks do you consider when searching for options plays?
Amber: I mostly sell puts on inexpensive blue-chip stocks that are in an uptrend. Most pay dividends, but they don't have to for me to earn income on them. These kinds of stocks make great long-term investments and are perfect for my options strategy.
Just about every blue-chip stock is "optionable," meaning I can buy and sell options on the stock. It's also easier to get the price I want since their options tend to be more liquid. Liquidity is one of the ways I reduce risk because that lowers trading costs and ensures that there will always be a buyer when it's time to sell.
Blue chips are also less risky to own than lesser-known small-cap companies. The chance of a blue-chip company going into bankruptcy overnight is small. That does happen, but it tends to be a process that unfolds over several months. By using short-term options I have very little risk that a stock will fall to zero in the time I am trading it. I also reduce risk by buying stocks that are going up. Bad things rarely happen to large, well-managed companies when their stock price is undervalued and rising. There were many opportunities to get out of big banks during the 2008 financial crisis and traders who ignored the trend-reversal lost small fortunes. I avoid that risk by avoiding stocks that are in clear downtrends.
As I mentioned before, I may be obligated to buy a stock from time to time. That's why I generally sell puts on stocks that pay dividends; it ensures that if I do buy the stock I continue to enjoy steady income. It's also why I tend to use lower-priced stocks. If I were to sell puts on Apple (Nasdaq: AAPL), I would need to be ready to spend more than $50,000 to buy 100 shares of the stock. Apple is a great company, but it would be impossible to diversify a small account if I put that much money into a single position.
Bob: Can you give me a step-by-step example of how to earn income selling puts?
Amber: Sure, let's look at an example using one of my favorite stocks...
Phillips 66 (NYSE: PSX) is the second-largest independent oil refiner in the country. It's also one of the largest pipeline operators, with 15,000 miles of pipelines responsible for moving oil from fields in remote locations to refineries. It uses its 10,000 service stations throughout the country to deliver gasoline directly to consumers.
PSX is a value stock trading with a price-to-earnings (P/E) ratio of less than 8. Earnings are expected to grow steadily at about 5% a year. The company has more than $4.4 billion in cash and cash flow from operations of more than $5.7 billion a year. PSX seems to have more than enough cash to fund its operations, expand and increase its dividend. For now, the company is using about 12% of its earnings to cover the dividend payments. That's well below the average payout ratio of about 30%, so PSX could more than double its dividend in the next few years.
Needless to say, this is a company I'm more than comfortable owning. But rather than buying PSX outright, I can sell puts and earn instant income. And if the shares move lower, I'll get the chance to buy shares at a lower price.
Let's use the Feb $48 puts at $1.15 as an example. That's a put that expires in February that pays sellers a $1.15 per-share premium, or $115 per contract. If shares of PSX trade below $48 a share, we'll be shareholders at a cost basis of $46.85 a share ($48.00 - $1.15, our premium).
(Note: Shares of PSX have moved higher since this interview was published. Do not attempt to make this trade.)
The $115 instant income is ours to keep no matter what. If shares stay above $48 during the next five weeks, the options will expire worthless and we won't buy one share of PSX. Most brokers will require a small margin deposit of about $960 when you make this trade. If the option does expire worthless, we get a 12% return on that deposit...in five weeks.
Here are two major risks in this trade:
- PSX could fall below the $48 strike price. If it does, we may have to buy shares at a price that's above current market price. We minimized that risk by selling options on undervalued stocks with a strong uptrend.
- The stock price could rise significantly, and we'll miss out on some of the gains. This does not bother me much because the premium received when we sold the put, $115 per contract, is a solid 12% return for a five-week period, and we'll have another chance to generate income by selling more puts when the option expires.
In other words, the worst case is buying PSX at $46.85, a 7.6% discount to current prices. We'd own shares at a dirt-cheap P/E of about 7, and we'd generate additional income using covered calls.
Bob: What do investors need to know before they can start selling options for income?
Amber: They will probably need to call their broker if it's their first time selling options.
Almost all brokers allow options trading, but there's a catch in that you might need to request approval first. This can be done with a form that asks questions about your income and investment experience.
A few brokers require minimum account sizes. That being said, I don't recommend that investors with less than $15,000 in their account sell options. As I mentioned earlier, there's a chance you'll have to buy shares when you sell puts. And for each put option contract sold, you could be required to buy 100 shares of the company. This combination can make it risky for investors with smaller accounts.
For example, let's say you have an account with $10,000 and you sell a put with a $25 strike price. In most cases, the options will expire worthless and the trade ends there. But if you're "put" the stock, you'll be required to buy $2,500 worth of shares, 25% of a $10,000 portfolio. Even if you love the stock, that's too large a position size (as a percent of the portfolio) for one investment.