Over the past year, we have experienced a 40-year high in inflation, a foreign war, a severe bear market, increased market volatility, and an uncertain economy. The financial turmoil has made it very difficult for the average investor to realize a consistent return on investment.
Despite these problematic market conditions, one strategy has produced above-average returns with relatively low risk. Before we delve into the strategy itself, let’s review some option basics.
Option Basics – A Refresher
There is no need to worry about complex mathematical formulas or equations. My mantra when it comes to option investing is ‘keep it simple’. Over the years I’ve found that the more complicated a strategy is, the less likely it will work over the long-term. We want to employ a strategy that has a history of profitability and is easy to follow.
Options are standardized contracts that give the buyer the right to buy (calls) or sell (puts) the underlying stock at a fixed price which is known as the ‘strike price’. These contracts are valid for a specific period of time which ends on option expiration day.
Options consist of time value and intrinsic value. In-the-money options consist of both components. At-the-money and out-of-the-money options consist only of time value. At options expiration, options lose all time value. When we are short an option, the time value of that option becomes profit at expiration regardless of the price movement of the underlying stock or ETF.
Create Your Own Weekly Paycheck
Most investors are not familiar with the concept of selling option premium to generate cash income. Selling option premium is a very simple but lucrative income strategy. When you sell an option, cash equal to the premium is immediately credited to your brokerage account. Unlike a traditional stock dividend, you don’t have to own the stock on the dividend date to receive a quarterly dividend and you don’t have to wait a year to receive a 2% or 3% annual dividend yield.
The key to selling option premium to generate cash income is to make sure the option you sell is ‘covered’. In this example, we’ll be using what is known as a ‘buy-write’ or ‘covered call’ strategy. In this strategy we buy in increments of 100 shares of a stock or ETF and sell a related call option. As options cover 100 shares of the underlying security, we want to make sure that we sell 1 call option for every 100 shares purchased.
Weekly covered calls are initiated by buying 100 shares of a stock and selling 1 weekly call option. As noted previously, when you sell an option, cash equal to the option premium sold is immediately credited to your brokerage account. This cash credit reduces the cost basis of the stock and reduces the overall risk of the trade. The great advantage to selling weekly calls is that you get to sell 52 options a year.
This strategy incurs less risk than owning the stock outright, but has the potential to deliver returns far in excess of simply owning the stock. Because the short option is ‘covered’ by the purchase of the stock or ETF, this strategy incurs limited risk. The weekly paycheck strategy can profit if the market goes up, down, or remains flat and gives us an edge in producing consistent returns during any type of market condition.
Weekly options are the ideal investment for turning small amounts of money into large amounts. This strategy is the ultimate investing game changer and can help us realize a more consistent profit flow.
Ideal Strategy for Today’s Volatile Markets
Selling option premium is a great strategy for profiting during hostile market conditions. Weekly options amplify this strategy as we get 52 opportunities each year to generate income as opposed to just 12 with monthly options.
Let’s take a look at an actual trade example. Semiconductors have been leading the rally this year and a currently on a ‘buy’ signal. The Direxion Daily Semiconductor Bull 3X ETF (SOXL) gives us levered exposure to this group and is a good candidate for our strategy.
With SOXL trading at 15.85, the April 14th 16-strike call is trading at 0.86 points and is an out-of-the-money option consisting of only time value. When you are short an option, the time value portion of an option becomes profit as the time decays to zero at expiration. At option expiration next week, the time value of this option becomes profit regardless of the price movement in the SOXL ETF.
Purchasing just 100 shares of the SOXL ETF and selling the 16-strike call equates to a cost of only $1,499. We can see a risk/return analysis of this trade below:
Image Source: Zacks Investment Research
Added Dimension of Profitability
Pay attention to the Stock Price % Change and % Return rows in the bottom section of the image. The first row (Stock Price % Change) shows underlying price movement in the SOXL ETF ranging from a -5% decline to a +5% gain over the next week. The bottom row (% Return) shows the corresponding return for our covered call trade.
If the SOXL ETF remains flat at 15.85 upon the weekly option expiration, the 0.86 points of time value in the 16-strike call becomes profit as the value of the option goes to zero.
If the SOXL ETF increases in price at option expiration, we still collect the 0.86 points in time premium profit. The short option may show a loss if SOXL increases above the 16-strike price, but this loss is more than offset by a gain in the ETF.
If the SOXL ETF decreases in price at expiration, we collect the 0.86 points in time value as the short option goes to zero. The 0.86 point profit could be offset by a loss in the ETF price depending on how far the ETF declines.
- SOXL remains flat at option expiration = +5.7% return (yellow highlight)
- SOXL increases in price at option expiration = +6.7% return (blue highlight)
- SOXL decreases -5% at option expiration = +0.5% return (red highlight)
When you buy a stock or ETF at a discount via the sold option premium, you can profit if the underlying security increases in price, remains flat, or even declines from your entry point. This results in a much higher probability that the trade will be profitable. It’s a big reason why this option income strategy has a huge advantage over a stock purchase strategy.
Cash on Cash Return
As stated above, each call option covers 100 shares of the underlying stock or ETF. Purchasing 500 shares of SOXL at the current price of 15.85 and selling 5 of the 16-strike calls at 0.86 would cost $7,495 ($7,925-$430) to initiate this covered call trade. If you were to rollover the short options weekly and receive a similar premium, you’d have the potential to collect $22,360 over the next year ($430 x 52). Receiving $22,360 in cash over the next year would result in a in a 298% cash on cash return ($22,360 cash income / original $7,495 covered call cost = 298%).
If you receive a 298% cash on cash return, a lot can go wrong and you could still profit.
- The underlying ETF can decline substantially and you could still profit from the trade
- If you have bad timing on entering the trade or encounter volatile price swings, you can still profit
- This gives the weekly paycheck strategy a huge advantage over simply owning stocks outright
There aren’t many times when we can profit even if our investment goes down in price. The weekly paycheck strategy offers very attractive returns and very low risk making it one of the best overall strategies for investors.
This strategy can be profitable in positive, sideways, or even slightly downward-trending markets. This allows us to maintain our positions through volatile markets, when normally we would be stopped out of our position. The weekly paycheck strategy incurs less risk than owning stocks while also having the potential to produce above-average gains.
I think the above analysis demonstrates why the weekly paycheck strategy should be a part of every investor’s portfolio!
— Bryan Hayes
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