Options trading can be a good way to generate a sideline income with higher returns than bonds and fixed deposits but it comes with risks that can potentially wipe out your entire capital. As someone who has lost more than half a million mostly in options trading, I think I am a good reference for the dangers of options trading.
Read more about my misadventure here:
6 Lessons Learnt After Losing 551k In 10 Years Of Investing & Options Trading | What Newbies Should Know They Start Investing/ Trading
Generating Income From Options Trading
In my 2 years of options trading, and experimenting with various strategies such as the Wheel Strategy, LEAPS Strategy and Vertical Spread Strategy to earn a sideline income, I come to realize that options trading is essentially a guessing game as the options buyer/ seller hopes to profit from guessing the right direction of the movement of the stock price.
If a trader is bullish, he/ she can sell PUT or buy CALL options.
If a trader is bearish, he/ she can buy PUT or sell CALL options.
Other Uses of Options
Options can also be used to complement your investment portfolio, such as buying a PUT option contract to protect the downside of your investments.
I have shared more in this article.
4 Ways How Options Trading Can Complement Your Investment Portfolio
The Only Certainty Is Time
No one can 100% predict the price movement, especially in volatile times like now. Some people believe the market has bottomed and the next bull run has started while the others believe that biggest crash is incoming. Inflation data, jobs data, Federal Reserves meeting outcomes, Fed speech can swing the market up and down. Through this volatility, the only certainty is time so we can make use of this to generate safe returns from options trading.
In any options contract, there is an expiration date and the contract covers the period from start date (of purchase) to expiration date. There is a time value which is already factored into the contract. One way to understand for the layman is to treat options contract as insurance policy, where the insurer covers the client for a period of time and this time period is a covered under the premium of the policy.
Further read here:
How Options Trading Works (Using Travel Insurance Plan As An Analogy)?
So, in order to profit safely from options trading, we have to make use of the only certainty of time to help us, i.e. we have to be options seller instead of options buyer. This is because with each passing day of the contract, the premium drops due to theta (time) decay. This means that even if the share price remains stagnant, the premium (aka contract value) drops because time has lapsed. To put it simply, a travel insurance plan will cost less if the coverage is for 1 month, as compared to 1 year, all else being constant. So, the option buyer will lose out on the premium dropping in value, unless the stock move in the direction he/ she anticipated, to offset the loss in time value of the contract.
On the other hand, Theta (time) decay works in the favor of the options contract seller. With every passing day, the premium drops in time value and the options seller can choose to buy to close the contract at a lower price.
To Be Safe Is To Always Be Prepared For The Worst Case Scenario
After going through the bear market of 2022, I realized that it is sometimes not about how much you can win if you are right, it is also about how you react when you are wrong.
What are your risk management strategies when trading? Do you cut loss before it is too late? Do you allocate only a certain percentage of your capital for trading? Do you have time and energy to keep monitoring the share prices so that you can react quickly when things start to turn against you? I have been there, made all the mistakes to learn the hard way.
The Safe Methods, Backup Plan & Risks
The safe strategies to trade options are to sell Covered CALL & Cash Secured PUT and in this article, I will share why I think they are the safest options strategies and how to fix the trade if things do not go your way.
I will start with selling Covered CALL (CC).
To refresh, selling CC means you agreed to sell at a certain agreed (strike) price if the underlying share price rises above the strike price on expiration date. A CC seller is generally bearish as he wishes to keep the premium as the contract expires worthless below the strike price.
Further explanation here:
Understanding How CALL Option Works
What To Do If The Trend Works Against the CALL Seller?
The premium of a CALL contract drops as the underlying share price drops and increases if the underlying share price rises. If the share price keeps increasing, the CALL seller will need to pay a higher premium to close the contract (at a loss) or risk selling all his shares at the strike price when the contract expires ITM.
If the strike price is the price that the CC seller is willing to sell, then it is no loss for the CC option seller to sell away his shares and redeem his capital. In turn, he gets to keep the premium of the contract.
If the CC option seller does not wish to sell his shares or by selling at his strike price, he will make a huge loss, then he will need to try this method of rolling the contract to a later date to earn more premium from time value.
What Does Rolling An Option Contract Means?
Rolling an option contract essentially means closing the current contract and opening up a new contract. For example, if you sell a CALL contract expiring on 17 March 2023, rolling means you buy the same CALL contract (same strike price and expiration date) to close it and simultaneously open a new options contract by selling a 2nd CALL contract expiring on 31 March 2023. Rolling a contract for an options contract seller will bring in extra premium, provided the strike price is the same.
Let’s look at a real life example:
Tesla is trading at $205 now and you sold a CALL contract at a strike price of $200, expiring on 17 March 2023. If Tesla’s share price remains at this level ($205) until 17 March 2023, the contract expires ITM and you will be forced to sell your shares at the strike price of $200.
If you do not wish to sell your shares at $200 as you think that Tesla’s share price is likely to fall in the coming weeks, then you can roll your contract to a later expiration date, say 21st April 2023.
By rolling your contract by a month, from 17 March 23 to 21 April 23, you will get an extra premium of USD 2465 – USD 1545 = US920 and another month of contract to wait and see if you are right (recall that selling Covered CALL is a bearish bet), If your breakeven price or capital invested in Tesla is $300 per share, then your returns for that month’s extension will be 9.20 / 300 = 3.06%.
If Tesla’s share price drops below $200 by 21 April 23, the contract expires worthless and you get to keep the full premium that you received when the contract was established as well the extra premium that comes from the extension. If Tesla’s share price is still hovering above $200, you can roll the contract again to a later date (from 1 week to 2 years later) and received more premium that comes from time value.
What Are The Advantages & Disadvantages Of This Strategy?
After experimenting with single-legged option strategies (buy/ sell CALL/ PUT options) and two-legged option strategies (Bull CALL spread, Bear CALL spread, Bull PUT Spread, Bear PUT Spread), I find this method to be less stressful and takes lesser time and effort to track, in terms of staring at price movements and monitoring stock prices everyday.
Unlike options contract buyer, you do not need to worry about time decay, i.e. your contract losing value by the day. Time is your friend as the premium decreases even if the share price stays the same and IV stays the same, and you can buy to close the contract at a lower price than the premium that you receive.
The disadvantage of this strategy is that you will need to own 100 shares of the underlying stock if you wish to sell Covered CALL against it. This means that you may need a huge capital upfront, depending on the share that you own. For example, 100 Tesla shares at $300 will cost you USD$30,000. There is another way to mitigate this by using vertical spreads but that comes with its own disadvantages as well. However, if you already intend to own the shares as part of your long term investment, then this strategy will help you generate extra sideline income, regardless of how the market fare in the short term.
Also, while you may profit from the premium of selling Covered CALL when the market turns bearish, it is worth noting that your shares are dropping in value and you are suffering a bigger unrealized loss or smaller unrealized gain (if current share price is still higher than your breakeven price). I have detailed more about this point in this article:
The Truth About Options Trading That The Gurus Never Told You | What Newbie Options Trader Must Know Before Getting Started
What Is The Risk For This Strategy?
The biggest risk that I can think of for this strategy is that there is an early exercise of the options contract by the options buyer and you are thus “forced” to sell your shares at the strike price, before the expiration date. On the other end of the options contract is a buyer who has the right to buy 100 shares from you at the agreed strike price. It is uncommon to exercise an options contract as the buyer can choose to sell away his options contract with a higher returns with his invested capital. However, it is possible that if the share price keeps increasing, he would want to own the shares instead for the long term and thus exercising his option to purchase at the strike price.
Take for example, if you sell an options contract for Tesla at $200. When Tesla’s share price keeps increasing to $300 or $400 and you keep rolling it to a later to earn the extra premium in exchange for the time value. If one day Tesla’s hits $500, and the options buyer who bought the options contract when share price was trading at $400, and thinks that Tesla could worth $5000 by 2030, he may just exercise his contract to buy at $200. Together with the premium he paid, his breakeven price on Tesla may be $450 and it is still a long way to his target price of $5000 by 2030. In this case, he may want to exercise the contract instead of selling the options contract for profit.
One way to mitigate this is to sell at a strike price that is closer to your break even price or only sell at a lower price if you are very bearish about the outlook of the underlying stock.
Selling Cash Secured PUT
The same strategy applies for selling cash secured price.
Refresh your memory on PUT option here:
How does PUT Option Works?
Selling a PUT option is generally bullish as the PUT seller expects the underlying share price to close above the strike price at expiration date.
However, if the share price falls instead of rise, the PUT seller will need to buy 100 shares of the underlying stock upon expiration date. If he does not wish to own the shares and still keep his capital, he can roll the contract to a later date and continue to earn extra premium with added time value to the contract.
This is somewhat different from the Wheel Strategy of letting the PUT contract get exercised and then sell Covered CALL against the newly owned shares. By rolling the PUT contract, the option seller does not need to own the shares and can keep earning more premium through added time value until the underlying share price finally closes above the strike price and the PUT option contract expires worthless.
Tesla PUT Options Prices at Strike Price on Expiration Date, 31 March 2023
Tesla PUT Options Prices at Strike Price $200 on Expiration Date, 21 April 2023
The risk is again early assignment where the PUT buyer chooses to exercise his contract and sell off his shares before the expiration. This is usually uncommon but still possible and the way to mitigate is to sell the PUT option at the price that you are comfortable to buy if it gets exercised or higher if you are very bullish about the company’s outlook. It is also possible to adjust the strike price upwards or downwards when rolling the options contract.
Concluding Thoughts
2021 had been a very bullish year while 2022 had been a very bearish year and it is easier to trade options if the trend is persistent towards a particular direction. You can choose to sell put/ buy call for bullish bets and sell call/ buy put for bearish bets.
However, 2023 has been a volatile year with swings up and down, affected by CPI / PCE data, Federal Reserves’ decisions at FOMC meetings, Fed speakers’ speeches, recession data and company earnings. In an uncertain year, even the best technical analyst cannot get it right all the time. Also, analyzing the charts takes skills, time and energy, and you have to closely monitor the price action to exit when the prices have changed. This can be very draining when you do this over a long period of time.
Thus, it is better to bank on the certainty of time and to profit from it by being an options seller. If you get it wrong, the contingency plan is to roll it to give you more time to get it right, while earning you extra time premium.
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