Options too risky for income investors? Maybe not

Puts and calls may seem a little bit exotic at first, but their potential to earn you some handsome extra income may well be worth it.

At the Money Reporter, we always look for ways to earn you that little extra bit of income, and here’s another one for you to consider. After all, we’re “The insider’s report for investors whose interest is more interest”.

Mind you, many investors are afraid of the options market. In fact, if we play a game of word association, it’s likely the term ‘options market’ would be responded to by something like ‘risky’.

But options in themselves are not necessarily risky. It’s how they’re used that can make them very risky, or not that much risky at all.

It’s like real estate. If you put $20,000 down on a house, finance the rest of the purchase, and then try to flip that house to another buyer within a few months for a $30,000 profit, that’s quite risky. But if you put $20,000 down on the same house, get a 25-year mortgage for the rest, live in the house and pay it off over 25 years, you’ve substantially cut your risk.

The point? It’s not real estate that’s necessarily risky; it’s how you use it that makes it more risky or less risky. It’s the same with options.

Here we discuss a strategy that is fairly safe for income investors to try. The others are usually for pros and the crazies. But not the one we talk about here.

(In fact, here’s a little side story: a Chicago options pro trader once told us that “the more exotic the name of the [options] strategy, the more likely you don’t want to do it.” He’s right. No reverse naked butterflies for us income investors.)

Perhaps the most basic and safe strategy in options is to start with is what’s called ‘selling covered calls’. The first step in executing this strategy is to already own the common shares you’re considering selling the call options against. That’s the ‘covered’ part; you have to already own the shares to be covered.

For example, let’s use BCE Inc. (TSX–BCE). You may have purchased 1,000 shares of BCE many years ago, perhaps at a price much lower than it’s trading today, which is about $52.

The next step is to sell some BCE call options on that existing stock position. Call options give some other investor a chance to buy your shares from you within a limited time frame.

Again by way of example, you might sell up to 10 BCE call options (each call option covers 100 shares, and you have 1,000 of them), giving another investor the right to buy your shares from you in the next three months at $55 a share.

Why would you do that? There are lots of reasons you would, but a main one is that this other investor will pay you money for the right to buy your shares at $55 per share within three months. Let’s say that ‘premium’, as it’s called, amounts to $1.00 a share. So you get paid $1,000 cash up front for your three-month commitment.

One of the risks you take with this strategy is that your upside is limited if BCE were to suddenly surge well beyond the strike price of $55, as your shares would likely be called away. Overall, though, selling covered calls represent an additional way to reap some income from stocks you already own.

 

Money Reporter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

Comments are closed.