Have you ever heard that trading options is a zero-sum game? What on earth does that mean? DEFINITION: a zero–sum game is a situation in which each participant’s gain or loss of utility is exactly balanced by the losses or gains of the utility of the other participants. Huh??? How’s this instead; a situation in which one person can win something only by causing another person to lose it. This in essence My Dear Readers, is option trading. One party has to lose in order for the other party to win or gain anything. Since 94% of put options (and 76.5% of all options – both puts & calls) expire worthless, it makes total sense that options writers (sellers) stand to gain while buyers of option premium stand to lose 8-9 times out of 10. Wow! You’d have better odds placing bets on a roulette table! Please refer to my previous articles: Is Wall Street a Casino? & Is Wall Street a Casino II for more on this subject. I have a confession to make! I purchased Index call options three separate times yesterday (3/2) and made a profit on each trade. Keep in mind I do this very infrequently and I only tie up 2-3% of my total trading capital for each trade. With volatility on the rise it’s far easier to make a profit on short term trades like yesterday. No trade lasted more than 2 hours in duration.
A few years ago I read a book on options trading that will forever change the way I invest in stocks. The book: The Options Machine explains how an investor can use options (specifically selling put options) as an alternative to buying common stocks. The strategy goes like this; you have a stock on your watchlist that you’d like to invest in, Kimberly Clark (KMB) for example. Yesterday the stock closed at 112.55. the 52-week high is 135.22 and the 52-week low is 109.51, the stock yields 3.55% which is attractive.
I’d like to buy KMB at 110. so instead of placing a limit order that may or may not get filled, I can sell the 110 strike put options. The May 110 puts closed at 3.63 (or $363. each), the bid closed at 3.20, the ask closed at 3.70. If I place a limit order to sell 1 contract at 3.50 (or $350.) and it fills, I collect the $350. premium up-front. If the stock closes below 110 on May 18th (date of the option expiring) I will be obligated to purchas 100 shares of Kimberly Clark at $110/share. If the stock closes anywhere above 110 on May 18th I keep of the premium I collected and the option expires worthless. Keep in mind that my actual cost basis is 106.50, because when the put option is exercised at 110 and I’ve already collected the premium; my basis is reduced by the amount I collected up-front. Here’s the math: $110. strike price minus the premium collected (3.50) equals 106.50! Thats a heck of a lot better than sitting on a limit order to purchase the stock at 110!
Even though option derivatives are traded, I consider this a low risk investment strategy. The key is to have the cash available for each stock where puts are sold. If I decided to place this Kimberly Clark trade on Monday I would want to set aside $11,000. to cover the purchase of 100 shares of the stock if the option is exercised. Otherwise this put-writing business is risky. If one doesn’t have enough cash set aside for this type of trading/investing, this could get very ugly if markets crater and put options get exercised. Theres always a caveat to any cool investment approach I blog about.
If this put-selling subject intrigues you I recommend purchasing The Options Machine Book (I do not personally know the author but I’ve profited from the system laid out in the book tremendously). The book details not only how to go about this system but also includes rules to follow. I began this type of trading (based on the book) several years ago and I’ve only had a few options exercised or “put to me,” They were disasters to begin with (GE, TEVA & HOG). What to do when a stock is “put to you?” I follow the book’s recommendation; when you take possession of the stock, immediately sell at-the-money covered calls on the stock and collect the premium. The book will expound on this subject.
For what it’s worth, I have a list of put options on 8 separate stocks that I’ve placed orders in for Monday’s trading. I may adjust the limit orders based on pre-market futures trading. This is a system that is unique and one that I do often. These are stocks that I’d like to own but at lower prices than where they’re currently trading. This system is a passive cash flow method of earning consistent income from the stock market without actually owning the stock outright. This is something that’s proven it’s worth over time and it’s a system that I’ll actively use for passive income with I’m fully retired and “on FIRE” in 2023.
DISCLAIMER: THIS IS NOT ADVICE! I am not an investment advisor, nor a professional in the financial services industry. Options trading and stock market investment do have risks. This blog is for informational purposes only and the reader is 100% risk responsible for any and all trades and investments made.