Selling these two options is a safer options strategy, but it still carries risks
While some investments are riskier than others, each investment vehicle carries its own risks. Not understanding the risks you’re playing with can lead to significant downside when things don’t go your way.
Covered calls and cash secured puts are often seen as ways to boost your income through the positions you already have in your account. In fact, you can crush dividend returns with the help of covered calls and cash secured puts.
I wrote an article detailing the math behind making 6-figures selling covered options which although has its merits, painted a very rosy picture of options trading.
The Math Behind Making $100,000 Each Year Selling Options
I painstakingly crunched the numbers so you don’t have to
While it painted possibilities, it didn’t clearly assess all of the risks. That’s the purpose of this article.
Some people see selling covered calls and cash secured puts as free money, but that is not the case.
Before we talk about risks, I’ll briefly explain the covered call and cash secured put.
For a covered call, you own 100 shares of a certain stock. You decide you have no problem selling it at a certain strike price. You then sell a covered call with that strike price and earn a premium.
For a cash secured put, you put enough money down to buy 100 shares at the price you want to buy it at. Rather than putting down enough shares, you put down enough money to buy 100 shares at your set strike price.
Let’s say XYZ stock trades for $100 per share and you have no problem selling it at $105/share. Let’s say you sell an option that expires in a week and earn $50 in premium.
You get that $50 premium regardless of whether the stock exceeds the strike price or not. If the stock stays under $105/share, you get to keep the shares. However, if the stock goes above $105/share, you are forced to sell your 100 shares.
For some people, this isn’t a big issue because they had no problem selling at $105/share when they set the strike price. However, if the stock surges to $120/share, you’ll wish you didn’t have to sell at $105/share.
To break even and buy back your 100 shares, you’d have to wait until the stock went back down to $105.50 (a $50 premium is a $0.50/share premium) or lower.
And if you sold the shares with capital gains, you have to include taxes in your break even calculation. You should keep potential taxes in mind when selling options. The premiums count as short-term capital gains. The amount you get taxed will depend on your income bracket, but short-term capital gains are taxed at a higher level than long-term capital gains.
If the options premiums bump you to a higher income bracket, you could end up paying extra taxes. If you’re already at a net loss, this won’t matter as much, but it’s always good to pay attention to how much you make from options because of the tax increase.
Cash secured puts function in the same way but in reverse. Instead of selling your 100 shares of XYZ at $105/share, you agree to buy 100 shares of XYZ at $95/share. If the stock price doesn’t go under $95, you keep the premium and your cash.
However, if the stock dips below $95, your investment turns into 100 shares rather than the $9,500 you invested to sell the cash secured put.
If the stock is at $94.70/share and you made a $50 premium ($0.50/share), you made a profit.
However, if XYZ stock goes down to $80/share, you’ll regret having been forced to buy it at $95/share from someone else.
If a covered call goes wrong, you can use cash secured puts to collect additional premiums and set a strike price where you would break even or make a profit.
However, you enter the risk of the stock price continuing to appreciate and falling further away from your break even price.
The same risk can present itself for selling cash secured puts where you start off at a net loss. If you sell covered calls at strike prices where you’ll break even, there is a risk that the stock price continues to decrease while you wait for the covered call to expire.
While the covered call will expire worthless and you’ll end up with the premium, you could end up with stock depreciation that makes it more difficult to break even in the future.
Here are some ways to mitigate risk when selling covered calls and cash secured puts.
Sell Further Out Options
I used to sell options every week. The issue with selling weekly options is that you get decent premiums but set strike prices close to the current price.
The risk is that the stock price can pop above your strike price in the case of a covered call or well below your strike price in the case of a cash secured puts.
I made solid money with weekly options but spent too much time looking at my portfolio hoping they would all expire worthless.
Further out options with lower premiums have a lower chance of getting exercised. While this results in fewer premiums, you won’t miss out on as much upside, and time decay has more time to act on the options price.
I’ll sometimes sell cash secured puts that expire in 2–3 days, but for volatile stocks I like more safety in case the stock suddenly spikes one day (i.e. Fastly is up 5% today and got to $96/share. If I still sold weekly covered calls, my strike price would be $100 which would be too close for comfort. However, since I spaced it out by a week, I made the same premium but my strike price is now $115.
If the option declines enough in value, sometimes it makes sense to close the position early and take your profits.
Don’t Sell Options Just Because You Can
Just because you have 100 shares of a stock or enough money for a cash secured put doesn’t mean you should sell options every week.
You have the ability but not the obligation to sell covered calls and cash secured puts.
On some weeks, it’s better to sit out. Other weeks present more optimal timeframes to sell options.
If you feel super stressed looking at your portfolio and your options positions, you’re giving it too much of your time.
Selling covered options that expire in 2–4 weeks that are far out of the money still provide upside and decrease the likelihood of the option getting exercised.
If you sell covered options, you should get clear on the type of benchmark you’re looking for. An annualized 20% return from selling covered options is possible but also carries higher risk.
On the other hand, a 10% annualized return from options premiums is more doable and carries less risk. You can also aim for a conservative 5% annual return and take on very little risk.
Use Options To Make Decisions You Would Have Made Anyway
Don’t sell options just because of the premiums. You should sell a covered option understanding you may part ways with 100 of your share or end up buying 100 shares of another company.
You should be fine with either of these decisions at your set strike price.
Only looking at the premiums can get you involved with dangerous stocks that can have a negative impact on your portfolio.
Take Nikola as an example. I’d never sell a covered call or a cash secured put on this company because I don’t want to own any Nikola shares.
A cash secured put with a strike price of $16 presents you with roughly $60 which is an instant 3.75% increase in your money. This option also expires in just 3 days which makes the premium all the better.
And if Nikola drops under $16, at least you didn’t buy it at $18.41/share.
Considering Nikola is a fraudulent company, those premiums are not worth the downside in the event Nikola plummets to $10 within the next 3 days.
While it’s extremely unlikely Nikola plummets that quickly, it has done back-to-back days of 10%+ losses and has plenty of more room to fall.
Some people fairly believe Nikola could eventually hit $0 and get delisted.
If you want to sell 100 shares of a company because you’re concerned, you can collect some premium along the way through a covered call.
However, if you look at the premium without looking at what you’d lose or get if the option gets exercised, you could expose yourself to a world of hurt.
Covered calls and cash secured puts are great investment vehicles to increase your returns. However, like any investment vehicle, these can quickly turn sour if you don’t understand the risks and rewards associated with these strategies.