The Magic of Selling Options Premiums
Updated: Jun 19, 2020
A few weeks ago I wrote a blog post about giving a boost to your FIRE plans through Crisis (Great Recession, Covid-19), rather than seeing your Financial Independence journey turn DIRE. You can read it here.
I got some feedback from some readers that they'd like to learn more about how I was using Options trading as key tool in the toolbox of fast-tracking my FIRE. Before going any further, I just want to mention you should definitely make sure you have a good understanding of Options Trading and the risks associated with it before jumping into it. That said, here we go...
First I built a Bot
During the Coronavirus Pandemic I found myself learning all sorts of new things, but perhaps the best thing that came out of it was the auto-trading bot I built that does the following:
Gathers Data: Gets charts data of all stocks I follow. Right now the bot watches everything in the S&P 500, along with a few others I'm interested in.
Analysis: Runs indicator analysis on every chart. For example, 50-day and 200-day moving averages, trend slopes, etc.
Training: I mark historical points on each chart where I would have bought or sold a stock to train the bot on my preferences and risk tolerance.
Alert: As the bot learns my patterns, it suggests buy/sell signals every day for all stocks in my watchlist.
Trade: Setting the bot in AutoTrade mode automatically buys and sells based on the training it has learned in point 3.
The bot is great, but it could not have prepared me for the Coronavirus Pandemic's effects on the stock market. Luckily, I was still just testing the bot with small amounts of my money, so no harm was done.
Getting to FIRE... fast
Here's where the magic happens, getting you to FI/RE fast. The bot doesn't stop at Stocks, but also suggests Options trades that will generate cash immediately, magnifying your returns on Stock investments even if the underlying stock loses value over time. Here's how:
Sell Covered Calls: When you own 100 shares of a stock, you can Sell Covered Calls. Selling a Call means someone pays you cash upfront for you to promise them you'll sell your 100 shares at a certain price on a later date if the underlying stock price hits a certain threshold by that date.
Sell Puts: If you've got cash or buying power through margin, you can Sell Puts. Selling a Put means someone pays you cash upfront for you to promise them you'll buy their 100 shares at a certain price on a later date if the underlying stock price hits a certain threshold by that date. I only do this when I plan to actually buy the stock anyway.
The key is to Sell Calls at a Strike Price where you can balance the cash you make on the sale with the probability that the stock price will not reach the Strike Price by the time the Option expires (unless you are happy selling 100 shares of the stock at that price). Sell Puts at a Strike Price where you can balance the cash you make with the probability that the stock price will not go below the Strike Price by the time the Option expires (unless you are happy owning 100 shares of the stock). The higher the probability that the underlying stock won't hit the Strike Price, the lower the Premium you'll be paid, and vice versa. It's all up to your risk tolerance.
A quick and realistic example: Groupon stock had been trading around $1.00/share during the COVID-19 crisis. Puts for Groupon at $0.50/share that expire within a week were trading for around $0.03. Options are traded in contracts of 100 shares each, so this means someone will pay me $3 for my promise to buy 100 shares of Groupon for $0.50 at the end of this week if Groupon goes below $0.50 by then.
If Groupon goes below $0.50/share, I buy 100 shares for $50. I already earned $3 Selling the Put, so ROI = 6%. Not bad for 1 week. There's always the possibility Groupon trades far below $0.50/share, but we only Sell Puts when we believe Groupon will be going up in the long term anyway, AND we are intending and happy to buy the underlying stock at the Strike Price.
If Groupon stays above $0.50/share, I buy nothing, the Option expires, and I keep the $3 for selling the Put contract. Infinite ROI, as cash is generated for no investment at all.
Next, let's imagine I did in fact have to buy the 100 shares for $50 when the Sell Put Option expired. Now I can Sell Calls on those 100 shares. Calls for Groupon at a $1.50 Strike Price that expire within a week are trading for around $0.02. I sell a single Call contract promising to sell 100 shares of Groupon by the end of the week at $1.50.
If Groupon goes above $1.50/share, I sell 100 shares for $150. I already earned $3 selling the Put, and $2 selling the Call, and I sell the 100 shares for $1.00 more than I bought them for. That's a 310% ROI within 2 weeks. While exciting to think about, it's unlikely that Groupon's stock price would go from $1.00 to $0.50 to $1.50 in a matter of 2 weeks, but I used simple numbers to illustrate the point.
If Groupon stays below $1.50/share, I keep my 100 shares. I already earned $3 Selling the Put, and $2 Selling the Call. That's a 10% ROI in 2 weeks, and I still own my 100 shares of Groupon. I can continue Selling Calls on my 100 shares of Groupon week after week, at Strike Prices just above what I think the share price will reach. Imagine earning 0.5%, or 1%, 2%, even 3% per week Selling Calls on 100 shares of Groupon. In a year, you could earn 50%, 100% or more on your investment.
Now that we've covered the basic concept, multiply the scenario to match the amount of cash you have available to invest. For example, after working a 9 to 5 for 15 years, let's say you've got $100,000 cash available for investment.
The scenario above is not unrealistic, and returns more than 2%/week on your investment.
Sell 1,000 Put contracts of Groupon, $3,000 cash earned for the promise to by 10,000 shares of Groupon at $0.50/each. (6% ROI)
The Option is executed and you've spent $50,000 on the investment.
Sell 1,000 Call contracts of Groupon, $2,000 cash earned.
In 2 weeks, $5000 = 10% ROI.
Sell 1,000 Call contracts every week = $2,000/week (4%/week)
In one year, your $50,000 investment has returned $107,000 in cash (214% ROI), and you still own 10,000 shares of Groupon, regardless of whether Groupon's share price has gone up or down. Ideally, you always want your underlying stock value to be growing at the same time, but it's not necessarily a problem if it loses value due to the cash generated by the Options market.
In the example, we used $50,000 for a single Stock, Groupon, but in reality you would do this with a handful of Stocks to diversify your investment. For example, invest $10,000 in 10 different stocks, or $5,000 in 20 different stocks, then let the bot tell you the following:
Buy/Sell indicators for Stocks in your investment watchlist.
Which Stocks provide the best Options within your watchlist, investment criteria, and risk tolerance.
Which Options balance ROI with the chance of the underlying stock reaching the Strike Price.
Weekly, Yearly, and Total Profits and ROI in both scenarios of either your Options being assigned (executed), or not.
Overall performance across all your holdings, both with and without the cash from Options sales included.
Everything I just said... It gets better.
Finally, Robinhood Gold accounts ($5/month) allow borrowing on Margin based on how much you've got in your accounts. The interest rate Robinhood charges on Margin balances is 5% APR, and they give you the first $1,000 interest-free. The Margin offered by Robinhood Gold accounts is perfect for Selling Puts. The Margin is available as collateral, but not actually used unless the Options is assigned (executed), so the collateral is available to generate cash flow for you, completely interest free. This is a great way to utilize buying power for free. Keep in mind, if the underlying stock's Price goes below your Strike Price, you'll be assigned to buy those shares at the Strike Price, which will start dipping into your margin at the 5% APR.
As I mentioned, make sure you understand what you're getting into and the risks associated with Options trading before making your first trade. I'm always happy to talk more about it, and look forward to feedback!