Hazelle
in Memos & Musings · 4 min read
Financial freedom involves having the income to enable us to be financially free. Stocks investing is one approach to allow us to generate additional income. But there are times when the equities market may be moving sideways or heading down where our portfolio remains underwater. If we are able to diversify our sources of income where we do not rely solely on stocks, that may greatly sustain the continuity of our income. Other than stocks, options is another great tool to generate additional income for investors.
Options is a versatile instrument and can be employed for various uses. For the purpose of generating additional income for investors, let us explore options as an option seller.
There are 2 types of options: call option and put option.
Sell covered call
If an investor owns at least 100 shares of a particular stock, he may consider selling a covered call to earn the option premium. This is how it works:
When the current price of the stock declines below the strike price of the call option, his underlying stock holding loses value. However, by selling the call option, he continues to generate cash inflow, which is the option premium that he receives for being the seller of the option. At the same time, as the current market price is below the strike price, his shares are not called away. Eventually when the share price rebounds, the investor will be able to profit from the capital appreciation on the underlying stock position over the longer term.
Conversely, when the share price of the stock increases above the strike price of the call option, his shares will get called away. The investor is now obligated to sell 100 shares of the stock at the price that he is willing to sell off the shares at, i.e. strike price of the call option. Nonetheless, the investor continues to keep the option premium, thus generating cash inflow from writing this covered call option.
Sell cash secured put
Now, consider the situation where you have identified a fundamentally sound stock which you are interested in investing in. By selling a cash secured put option, this is how it works:
When the current share price goes up, an investor may be unwilling to purchase the shares off the market due to the high prices. Instead of doing nothing while waiting for the share price to come down, an investor can sell a cash secured put option to earn some additional income (put option premium).
When the share price declines below the strike price, the put option will be assigned and the investor is now obligated to purchase 100 shares of the stock at the price which he desired, i.e. strike price of the put option. Regardless, the investor gets to keep the option premium and earn the additional cash inflow.
An investor generates additional income no matter which direction the stock price moves
Therefore, as you can see from both scenarios, be it selling a covered call or a cash secured put, we get to generate additional income by earning the option premium regardless of how the stock price moves. In addition, we may be able to buy or sell the stock at the price which we are happy to do so at.
As option sellers, we also do not have to be precisely accurate in the stock price direction and we should have constructed the trade such that we will be comfortable with all the eventual outcomes no matter which way the stock price moves.
In the case of selling a cash secured put, an investor gets paid while waiting for the stock price of the stock to come to the desired level. As for selling a covered call, an investor gets paid while waiting for share price recovery for the stock he already owns.
Diversification of income sources on the path towards financial freedom
By employing options for a stock investor, this diversifies the investor’s sources of income. This is important especially under the current rising rate environment, a simple diversification strategy of stocks-bonds may no longer be helpful. Under the current stock market context where the equities are beaten down, being an option seller can continue to generate some additional income for the investor and improve the performance from the equities portfolio.
Investors may also employ strategies to, for instance, sell covered calls on a partial of the portfolio, say only 50% of the stock portfolio. This allows the investor to receive some option premium while also being able to participate in any upside for the remaining 50% of the stock portfolio.
Hence, diversification of the sources of income through both stocks and options allow investors to continue to build up the size of the portfolio, of which part of it may eventually be deployed into dividend stocks to generate regular cash inflow to cover for daily expenses upon retirement. Ultimately, generating additional income is the key towards achieving our eventual goal of financial freedom.
Through employing relevant options strategies, it may allow us to still eke out gains amid low expected returns from the individual stocks, like in the current climate that we are facing. This is how we make the most when markets offer the least.
If you are keen to learn more in detail on how to use options as a stock investor to build up your investment portfolio, you may watch this video to find out more. Alternatively, come join us in the upcoming workshop to learn the basics of Options 101 in-person with us!
About Hazelle
Chief trainer of The Moneyball Investors Playbook program and founder of The Joyful Investors, a financial education firm that seeks to help avid investors learn to invest better and make the journey a joyful one. I graduated with a first class honors in Bachelor of Accountancy from Nanyang Technological University (NTU) and started my auditing career in one of the Big Four. I believe that once we know how to build our wealth sustainably, we can then live our best lives ever.
Important Information
This document is for information only and does not constitute an offer or solicitation nor be construed as a recommendation to buy or sell any of the investments mentioned. Neither The Joyful Investors Pte. Ltd. (“The Joyful Investors”) nor any of its officers or employees accepts any liability whatsoever for any loss arising from any use of this publication or its contents. The views expressed are solely the opinions of the author as of the date of this document and are subject to change based on market and other conditions.
The information provided regarding any individual securities is not intended to be used to form any basis upon which an investment decision is to be made. The information contained in this document, including any data, projections and underlying assumptions are based upon certain assumptions and analysis of information available as at the date of this document and reflects prevailing conditions, all of which are accordingly subject to change at any time without notice and The Joyful Investors is under no obligation to notify you of any of these changes.
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