Sell Options for Income
When we want to sell options for income we start with a company we want to own. We have a few steps to complete to make that decision.
The first thing we do is research the company to be sure we can understand their operations and industry. Here’s an interview with Charlie Munger that talks about how to determine if we can understand a business. We look at the company to see if it’s in an industry we’re familiar with. That could be because we have experience working in the industry or we’ve owned other companies in the industry. We could decide that we want to learn the industry. If that’s the case we would subscribe to some of the industry publications. We’d also buy some of the company’s products or use their services. We might have a fried of family member who uses their product, and we could consult with them for a review.
Once we feel comfortable that we can understand what the company does we’ll do a high level review of the company’s financial information. Here’s where we do that. We’re basically looking to see how the company stacks up with their competitors from a key metrics perspective. We like to start with revenue, debt, gross margin, operating margin and return on invested capital. If the company compares well to their competitors on these high level metrics we dig deeper into industry specific metrics. If the company is number one or two in their industry for most metrics it’s likely they have a moat. That’s Warren Buffett parlance for a long term, sustainable competitive advantage. The objective is to find a company that is the best in their industry.
Before we use the company to sell options for income we want to look at how management runs the company. This means going to the Investor Relations section of the company’s website and finding their recent quarterly earnings calls. We like to listen to at least the three most recent calls, going from oldest to newest. This was we hear the trends from the CEO and CFO and also the questions the analysts are asking. We like to listen to at least a few calls so we can hear about the consistency. Is management focusing on the same things from one call to the next? Are their priorities changing, or are they consistently focusing on the same goals? Does their approach seem to put the best interest of their shareholders first? It’s also a glimpse into the personalities of the leaders, which impacts the company’s culture.
Then we look at the CEO as a person. Does the CEO hold shares of the company’s stock? Do they hold enough shares that it makes up a significant portion of their net worth? Have they been selling or buying shares recently? When their stock options vest, are they keeping them or selling them right away? Is the company returning capital to shareholders via buybacks or dividend? If the company is doing share buybacks, are they buying those shares at a reasonable price or an inflated price? If we’re going to put our capital into the company when we sell options for income, we want to be sure the leader of the company also has capital at stake. Here’s the CEO checklist we use when we research a company.
We also look to see if the expert fund managers are investing in the company. A hedge fund that manages $100 million or more must file a 13F with the SEC each quarter. Managers of funds this size have lots of resources available for research. So we like to monitor what these fund managers are buying and selling to identify trends. If we come across a company we like with strong metrics and a solid management team, we look to see how many fund managers own shares of the company. We like to see more than one fund own a company we’re thinking of investing in. We also like to see a healthy allocation of the fund’s capital to the company. That means more than just 1% of the fund’s capital. If a few large funds are building a stake in one company, we see that as a positive signal.
Going through each of these steps takes some time. When we get to a step and aren’t comfortable with the results, we discard the company and look for another. The idea is that we only want to sell options for income on a company that is stronger than the others in that industry. A company that we’re comfortable owning for the long term, with a management team we like.
Before we sell options for income on the company, we need to be sure what the company is worth. We want to buy shares at an attractive price, not when shares are trading near an all time high. So we watch the company and wait for the share price to drop. Eventually there may be problems with a product, the company, the economy, or something else that drops the trading price. When that happens we research the event that is causing the trading price to fall. Here’s an interview with Warren Buffett and his Ajit Jain that talks about how events work.
When we research events we look at how the company handled events in the past. We look at the resources the company has available. Lots of cash on hand without much debt and a stable leadership team all help. Competitors who have lots of debt without much cash on hand and job hopping CEOs can also help. We want to see a clear path forward for the company. Is the event a short term hiccup, or does is threaten the existence of the company? If we can find facts that show how the company will overcome the event and be a stronger company five years into the future, we may use the company to sell options for income.
When we get this far in the process we’ve identified a company we like. We like what they do and how they do it. We like the leadership team and feel they act in the best interest of the shareholders. The leadership team has a significant portion of their net worth in the company, and the leadership team is stable. The company is an industry leader for their key metrics and the metrics are trending in the right direction. There’s an event that is impacting the trading price. We understand the event and see a reasonable path forward for the company to overcome the event. The company is trading near a price we’re comfortable buying shares. We have capital for shares of the company, and we’ve broken that capital up into at least five tranches.
Before we talk about how we can sell options for income, let’s go through some stock option contract basics. There are two types of options, puts and calls. We can do two things with those options, we can buy them or sell them. We focus on the selling of option contracts. When we enter an option contract we sell to open the position. When we sell a put option we’re making a promise to buy shares of the company. When we sell to open a call option, we’re making a promise to sell shares of the company. Both contracts are for a specific strike price for an agreed upon amount of option premium. The buyer of the contract can exercise it on or before the contract expiration date.
Since we’re selling the contracts, we receive option premium when we enter the contract. We keep that premium regardless of the outcome of the contract. When we sell a put option we’re making a promise to buy shares of the company at a certain price. We pick that price, along with the premium we’ll accept to enter into the contract. We also pick the expiration date. So we pick the company, the price we’re willing to pay, the premium we get paid, and the expiration date. We’re getting paid to do what we want to do (buy shares of a company we like) at the price we want to do it. The same can be said of selling covered calls. We’re making a promise to sell shares at a price we want to sell them. We also choose the premium we’ll accept and the duration of the contract.
We only to sell options for income on a company we want to own at the strike price. If we are not comfortable owning the company at the strike price we will not sell to open that put option contract. When we do make that promise to buy shares of a company at the price we want to buy the shares, we need to have enough capital available in our brokerage account to cover the cost of the shares if we are assigned. One option contract is for 100 shares, so if we sell to open a cash secured put option, we’ll need 100 times the strike price available in our account. If we select the $30 strike price, we’ll need $3,000 available. If we select the $200 strike price, we’ll need $20,000 available per contract.
When we allocate that capital to a put option we’re locking up those funds until the contract expiration date. We want to be sure we’re generating an acceptable level of return on that capital. So we use this approach to evaluate which contract to use when we sell options for income. We look at the premium we receive for entering the contract. Then we divide that into the strike price. Let’s walk through an example.
We have a $50 strike price with a premium of $0.45. We divide the $0.45 in premium into the $50 strike price and we get 0.009. Then we look at the duration of the contract and see how many times we could do a trade of this duration over the course of a year. This trade is for 9 days. There are 365 days in a year, so we divide that by the 9 days this contract is active and we get 40.5. Then we multiply the time multiplier of 40.5 by the capital multiplier of 0.009 and we get 0.365. That’s an annualized return of 36.5%. That’s better than we’ll get with a Treasury Bill. We use this Stock Option Contract Return Calculator. The risk is that we have to buy shares of the company we wanted to buy at the strike price we chose.
We typically sell a cash secured put option contract a few times before we buy shares. Each time we sell an option contract we collect (and keep!) the option premium. It’s a usually few cents per share on each contract. By the time we buy shares we’ve built some equity in the shares we own. Then we sell a covered call at the assignment strike price on a portion of our position. That gives us more option premium. Depending on the company, we might also be collecting dividends. Here is the Basis Reduction Template we use to track our cost basis on each company we trade.
We continue to sell options for income and accumulate shares until we’ve filled our tranches. We might also stop selling puts if something changes with the company so we no longer want to buy more shares. Then we start selling covered calls to exit the shares as the shares begin trading higher. When the share price gets back up to where it was when we started to research the company we’ve bought shares with put option contracts, sold shares with covered calls, and reduced our cost basis on the shares we still own. We’ll have some shares called away with covered calls to reduce our basis further. Our goal is to reduce our cost basis down to zero and still own shares for the long run. Then we take our initial capital and start again with another company. Here are examples of our recent trades.