How To Trade Options Safely

Traders work in the S&P 500 options pit at Cboe Global Markets.

Mention stock options to most individual investors and the response is likely to be either a look of fear or bewilderment. Stock options, after all, are thought to be for traders, for those who like to take risks, the gamblers.

However, what many individual investors may not realize is that stock options are useful tools for those interested in conservative, income-generating strategies. In fact, options are widely used in this way by the most successful professional investors on the planet.

Even if you’ve never traded options, most online brokerages make it easy to get up and running quickly and start earning extra income from stocks that you already own, and from ones that you wouldn’t mind owning. Establishing a position in a stock that you want to buy via selling options allows you to reduce your cost basis significantly, typically from 2% to 5%, or even more.

The two strategies I most frequently employ in trades recommended every Tuesday and Thursday afternoon in Forbes Premium Income Report are selling covered calls and selling puts. These two strategies are essentially bullish positions on underlying stocks, which are all dividend-paying stocks that appear to be undervalued based on discounts to historical valuation ratios like price-to-sales, earnings, book value and cash flow.

In this article, I spell out the potential risks and the rewards of both of these strategies, and walk you through real-world trades that employ these strategies. First, let’s review a few basics of options.

With inflation running at 4.0%, dividend stocks offer one of the best ways to beat inflation and generate a dependable income stream. Download my special report, Five Dividend Stocks To Beat Inflation.

Puts And Calls

Stock options are traded on exchanges as contracts that entitle, but do not require, the owner to buy or sell 100 shares of the underlying stock at a fixed price any time before the predetermined expiration date. Options come in two types, puts and calls. Put options allow the holder to sell at the stated “strike” price, whereas call options give the holder the right to buy at the strike price at any time until expiration. Buyers of options pay what’s called a “premium” for these rights and that premium fluctuates with the price of the underlying stock, the time until expiration, the proximity of strike prices and any dividends to be paid to owners of the stock.

Generally speaking, premiums on call options increase as the stock price rises, and put options rise in value as the stock price falls. Options sellers receive money up front for taking on the obligation either to buy or sell the underlying stock. “Writing covered calls” on a stock that you already own means that you sell the right to someone else to purchase the stock at a certain price until the expiration of the options contract. When you buy a stock and simultaneously write covered calls, it’s referred to as a “buy write.”

Here’s an example of a buy write on Intel (INTC), which closed on June 20 at $35.00 per share. If you don’t believe that the stock will trade much above $36.00 in the next month, you could sell $36 July 21 INTC calls. The more distant in the future the expiration, the more money you’ll earn for selling call options. Looking at the July 21 expiration, $36.00 calls last traded at $1.23 per option. Because each option covers 100 shares of stock, you would earn $123 for selling one “contract” of these calls.

Etrade

Each transaction has a buyer and a seller. The buyer of the $36 July 21 call options would have the right to buy Intel at $35 per share until the options expire at the end of the trading day on July 21. This means that as the seller, you would be committed to selling Intel at $36 at any time until the options contract expires.

Selling these calls as part of a “buy write” (buy the stock, write the calls), your cost basis in Intel would be $35.00 (the price to buy the stock) minus $1.23 (premium earned from selling the calls), or $33.77. This “net debit” is the amount you need to pay per share to establish the position.

If Intel stock closes at $36.00 or lower on July 21, the call options will expire worthless and the seller of the call options keeps the Intel shares plus the $1.23 per share in premium earned for selling the calls. In the case of a buy write as described above, you would still hold Intel at a cost basis equal to the net debit of $33.77 per share.

These calls would expire “in-the-money” if they close $0.01 above the $36.00 strike price on July 21. If this happens, the seller of the calls would need to sell Intel stock for $36.00 per share, but they would keep the $1.23 per share earned when they sold the calls. The profit would be the difference between the strike price ($36.00) and the net debit ($33.77) or $2.23. With $33.77 per share at risk, the $2.23 per share profit would produce a total return of 6.6% over the one-month holding period. Multiply that by 12 and you get an annualized return of 79.2%.

Trading Options

Decades ago, only big brokers and institutional investors could benefit from selling options for income. Options trading took place “over-the-counter” without the standardization and confidence that comes from trading on an exchange, which eliminates the risk of somebody failing to live up to their end of the trade. In 1973, the confluence of computing power and mathematical models made it possible for options to begin trading on the newly-created Chicago Board Options Exchange. Exchange-trading provides an orderly process of matching the highest bids with the lowest ask prices and ensures that nobody can stiff the other guy by walking away from trades.

Today it’s easy to get options quotes from just about any finance website or online brokerage. The below options chain on General Motors (GM) is a grid showing the calls (left side) and puts (right side) at various strike prices listed from low to high. Below I’ve selected the GM options that expire on July 21, 2023 at strike prices between $34.50 and $37.50. The stock last traded at $36.16.

Etrade

Shaded boxes show “in-the-money” contracts. For call options, this means that the current stock price is above the strike price of the calls. Put options are in the money when the current stock price is below the strike price of the puts.

You can see each option’s last trade price, along with the current bid and ask. The bid is the highest price a potential buyer is willing to pay, and the ask price is the lowest amount a potential seller would accept for the option. Volume shows the number of contracts traded today, and open interest measures contracts that have yet to be closed out.

You can always sell at least at the bid price. Each contract covers 100 shares of the underlying stock, so you would multiply by 100 and get $105 for the $36.50 July 21 calls. By taking in that money (the premium), you would be on the hook to provide the owner of the option with 100 shares of GM at $36.50 apiece anytime until the close of trading on July 21.

This kind of trading is speculation. Of course, not every speculative trade works out very well. Profits can be big, but the risk can be extreme due to the limited time frame and options expiring worthless in most cases. In the above example, if General Motors closes at or below $36.50 at expiration, the position is a total loss for the call buyer.

Options expiring worthless are bad for speculators, but it’s a favorable outcome for options sellers. This means they keep the premium earned for selling the options and are free from any further obligation to do anything.

The recommendations in Forbes Premium Income Report focus on SELLING options to earn extra income and to reduce risk, rather than buying options with speculative intent.

We sell puts, and we sell calls. What we generally want is for those options to expire worthless. If the options expire in the money, we want to make sure that the stock we end up owning is one that’s worth owning. That’s why I select only dividend-paying stocks trading for reasonable valuations as the underlying stocks for our trades.

In some cases, we establish a new position in a stock and then simultaneously sell call options against it. That’s called a buy-write. On the other hand, you do not initially buy the stock when you sell puts. You receive a premium for agreeing to buy the stock at the strike price up until the expiration of the options. If the stock stays above the strike price of the puts, you keep your premium and move on with life. If the stock closes below the strike price, you are obliged to buy it, but your cost basis is reduced by the amount of money you collected up front when you sold the puts.

Selling puts or calls both put money in your pocket up front, and commit you either to buy or sell the underlying stock if the strike price is hit. The premium they provide can be a powerful one-two punch of income when you combine them with dividends. Ideally you can collect a monthly paycheck from your stocks by pocketing quarterly dividends four times per year, and selling covered calls on your stocks every 45 days.

Covered Calls And Buy-Writes

If you own at least 100 shares of a stock, you’re able to sell call options on that long position and receive a premium for doing so. The downside is that you surrender the ability to participate in gains beyond the strike price of the options. This income generation strategy for an existing position is known as selling covered calls. If you buy the stock and sell the calls simultaneously, it’s referred to as a buy-write since you are buying the stock and writing (selling) the options.

One of the advantages of covered calls and buy-writes is that they are conservative strategies that allow an investor to take a larger position while enforcing a sell-side discipline. In addition, they can make money in four out of five possible scenarios. Among the disadvantages are surrendering potential gains in exchange for reducing risk.

Covered calls and buy-writes tend to be most advantageous when used with stocks that trade sideways or that move slightly higher. In a raging bull market, you may have to sell some stocks that keep going higher, but that comes with the territory since this strategy focuses on generating income and producing stable returns. Because you own the underlying stock there is still downside risk, but it is offset by the amount of income you’re able to generate by selling the calls.

Here is a real-world example of how a buy write on a dividend-paying stock. On May 11, 2023, I recommended buying 200 shares of lottery and gambling systems provider International Game Technology (IGT) at $26.27 per share and selling $27.00 June 16 calls for $0.87. The net debit to establish the position was $25.40 (stock price minus call premium), which was our cost basis in IGT. We earned a $0.20 per share dividend on May 24, IGT’s ex-dividend date.

At expiration, IGT closed above $27.00, so we had to sell at $27.00. This earned us a total of $1.80 per share on $25.40 per share at risk, or 7.1%.

There are five possible outcomes when you do a buy-write, and in only one of them would you lose money. That’s if the stock falls below your cost basis at expiration. In each of the four other scenarios, you would earn you a profit.

If the stock price is above the strike price of the calls at expiration
If the stock goes nowhere
If the stock trades slightly higher
If the stock price falls but stays above your cost basis

If you can repeat the process again and again while holding onto your underlying shares of the dividend-paying stock, you can create steady flows of income. This is highly desirable for many investors who are trying to generate income from their investments.

When Covered Calls & Buy-Writes Make Sense

As you can see from the example, there are numerous advantages associated with buy-writes and covered calls, including:

Generating income
Securing profits
Wanting to sell your stock but at a higher price than current market price
Lowering your total cost to acquire share
Imposing a sell-side discipline

Selling Cash-Covered Puts

Unlike buy-writes or selling covered calls, selling cash-covered puts is a strategy that is undertaken without initially owning the stock, but you should be prepared to own it. In fact, your broker will require that you have adequate funds or margin available to buy 100 shares of the underlying stock, just in case, before you can place the trade.

Selling puts is a way for investors who are bullish on a stock to be able to buy it below the current market price. If the stock price is below the strike price of the puts at expiration, your cost basis would be the strike price minus the premium you received. If the price of the stock goes up and keeps going up, the put-seller keeps the premium. Perhaps the most favorable outcome would be for the stock price to be less than the strike price at expiration, triggering assignment, and then rallying strongly afterwards—while you own it.

Here is an example of a put-selling trade featured in Forbes Premium Income Report. On December 4, 2018, shares of snow plow maker Douglas Dynamics (PLOW) traded at $35.81. For $1.70 per share, we sold $35 puts that were expiring February 15. At expiration, PLOW closed at $36.24. Because it was above the $35 strike price of the puts we sold, we kept our premium of $170 per contract for a 73-day return of 5.1%, or 25.9% annualized.

If PLOW had closed at or below $35, you would have been compelled to buy the stock at that price, but your cost basis would have been $33.30, reflecting the premium earned selling the puts.

The maximum gain, not counting the potential for a stock to rally after you are assigned it, is limited to the premium you receive for selling the put. The maximum loss is substantial, cushioned only by the premium, if the stock drops to zero.