Freedom 48 Investment Toolkit: Using Options To Improve Investment Returns

Using Options To Improve Returns
 

In my previous post, I covered the basics of margin account and options. For this post, I’ll go over the strategies that I used to buy stocks cheaper, sell stocks at a higher price, making money without selling or buying the actual stock, and pay less taxes. To fully execute these strategies, the basic financial and options trading experience requirements mentioned in my margin account and options post must be met. So let’s dive in.

Writing a covered call option

I often use the covered call option strategy to make extra income for the current year or to improve future return of my investment portfolio. A really good time to execute this strategy is when a good dividend paying stock that I own have increased dramatically in value in a short period of time. For example, the Bank of Nova Scotia (BNS) common stock has increased over 35% in value year-to-date. At the time that I am drafting this post (December 14, 2016), the BNS stock price is about $77, it’s paying $0.74 per share per quarter, which is about 3.84% (=$0.74 * 4 /$77) in annual dividend yield. I will write a covered call option contract (1 contract = 100 shares), with a strike price of $84, expiring on January 2018 and collect about $2.00 per share in premium (or $200 in fees). If the option is exercised (that means I’ll have to sell my BNS stock at $84), I am more than happy to sell. I will be guaranteed an additional 15.53% (=[$84 + $2.00 + 4*$0.74 – $77]/$77) return on top of my current return in about one year when I factor in the price appreciation, fee collected and dividends. If the option is not exercised, it’ll be expired and worthless, I am still collecting my usual $296 (=4*100*$0.74) in dividends and $200 in free money from the purchaser.

Writing a naked put option

Sometimes, there are a few really great stocks that I wanted to buy, but it never seem to go on sale (the price of a stock drops by at least 15% by my definition) and I don’t want to pay the current price for those stocks. Enters the naked put option, it can help me buy a stock cheaper than the current price. For example, I think that The Coca-Cola Company (KO) is a great stock to own. However, it rarely reaches a price point that think is cheap enough to buy. Until recently, when the price of The Coca-Cola Company (KO) drops to about $40 per share (from a high of $47.13). At that point, I sold one naked put option contract with a strike price of $38 per share, expiring on January 2018 and collected about $2.25 per share in premium (or $225 in fees). If the option is exercised (that means I’ll have to buy 100 shares of KO stock at $38). I’ll be very excited to buy it because the price that I’ll be paying is only $35.75 per share (=$38 – $2.25, you get to reduce your average cost by the premium that you collected if the option is exercised), which is about a 24% discount from the highest price point of $47.13. If the stock never goes below the $38 mark at any time before January 2018, the option will expire worthlessly and I get to keep the premium of $225 without investing any money in KO.

Writing options just to collect premiums

When I am writing options, either naked put or covered call options, I don’t always want to buy or sell the stocks. However, I have no issue buying or selling the stock if the purchaser exercises the option, but I prefer just to keep premium for free. In that case, I’ll write naked put options that are at least 15% to 20% below the current price and covered call options that are 15% to 25% above the current price. I will be collecting a bit less premiums comparing to the options that I write with strike prices that are closer to the current stock price. If either option is exercised, I will be buying stocks even cheaper or selling stocks at higher prices and make more money. Recently, I bought 100 shares of Chipotle Mexigan Grill Inc. (CMG) at about $430 per share. After buying it, I wrote 1 covered call option contract with a strike price of $600 and an expiry date of January 2018. I collected about $1,600 (= $16 * 100) in premium. If the option is exercised, I will make an eye-popping 43.3% (=[$600 + $16 – $430]/$430) for this investment. Otherwise, I get to keep $1,600 for free.

What are the risk associated with these strategies?

With any type of investment strategy, there is always risks involved. However, the risk can often be managed or mitigated. The rule of thumb that I use to executing these strategies are to select the stocks that have brand name recognition, have been paying dividends continuously (and a history of increasing dividends is even better), and good cash flow to pay dividends. The worse case scenario is that you’ll lose the value of the contract less the premium that you collected (= strike price * 100 – premiums). The same can be said for any investment, not just stocks. If a company has had brand name recognition, have been paying dividends for years and maybe even raising dividends every year, the chances for that company worth zero in value around one year of time is quite remote. Hence, my risk of losing a significant amount of my money is managed.

What are the tax implications

For the cases that the contract expired worthless and you keep the cash, the proceed will be taxed as capital gain, which means you only add 50% of the gain to your income to be taxed (in the year that you received the cash). In the case that the covered call contract gets exercised, 50% of the premium is taxed in the year that you received the cash and 50% of the gain from the stock sale is taxed in the year that you sell the stock. On the other hand, if the naked put contract gets exercised and both the transaction for the option and the purchase of the stock happens in the same year, you pay no tax and you just lower your average cost of the stock by the premium amount. If the transactions occurred in different years, 50% of the premium is taxed in the year that you received the cash and report a loss for 50% of the premium in the year that you buy the stock. The net effect is almost zero, but the government wants you to report the income in the year that you earn.

My two cents

For me, I’ve never purchased an option before. I only write options as I prefer to get cash from people instead of giving my hard earned cash away and hope that a stock price goes up or down within a one year period. The three main purposes for me to write options are: to buy stocks at a cheaper price or to sell stocks at a higher price that will make me greater profits or get free money when nothing happens. I think buying an option is more speculative and I let other people do it.

 

The options are there (pun intended). You just have to choose which path you want to take to build your wealth. Would you put this strategy to your investment toolkit?

&bnsp;

Leo T. Ly, Canadian Personal Finance Blogger/Enthusiast and a Realtor Living in the Markam, Ontario, CanadaAbout Leo
I am a Canadian personal finance blogger/enthusiast and a Realtor living in Markham, Ontario, Canada. I built a net worth of a million dollars over a ten year period. I did it by being a disciplined saver, taking advantage of income tax rules and borrowing money to invest rather than for consumption. I am often excited to take advantage of free money from employers and governments in addition to building more passive income sources. After accumulating my first million dollars, I am now embarking on a second journey towards achieving financial independence. On this journey, I will strive to increase my net worth to two million dollars and retire by the age of 48 - Freedom 48. Come along and follow my journey on Facebook, Twitter, Pinterest or Google Plus.



There are 15 opinions expressed on this post.

  1. My brother in law’s uncle employs a covered call strategy for 99% of his investment income. He’s been doing this strategy for the last fifty years and he build up a significant nest egg which allows him to live where ever he wants in the world.
    One of these days my brother in law and I are going to fly out to learn at his feet but I loved reading your overview. It’s definitely something that I need to look further into.

    1. Hi Mustard Seed Money,
      The covered call option strategy is just one of the components in my investment toolkit. I truly believe that it’s not how much you make, it’s how much you get to keep. So with every strategy that I look into, I always ensure that I find a tax efficient way to keep more of the money that I make. BTW, I visited your blog and I enjoyed your work or retirement post. It really motivated me to explore more investment strategies and reach my retirement date sooner.

        1. From a personal perspective, once you learn the tax rule, you will benefit it for life as you need to do income tax every year. In terms of new tax rules, I usually tend to only dive deeper into the ones that affects my family and there are not a lot of new rules every year. I use a tax software to do my tax every year and I have a checklist of all the deductions that I reported the previous year. It’s wash and rinse every year. Spoiler alert, my next post will be about taxes :).

  2. I definitely agee with the view on option speculation. Leave the guess work to others and pocket their premiums first. I find that it’s more profitable when the stock is more volatile.

    1. Another thing that I noticed is that the option market on the U.S. stock exchange is much more liquid and the spread between the bid and ask is much more narrower than the ones on the TSX. Good to know that we have the same view on the option speculation. Thanks for stopping by.

  3. The idea of selling puts to invest in a stock is a great one, because it reduces the cost basis. If the stock drops, there is no disadvantage, because if you were buying the stock in the first place, the put premium would help reduce the cost, plus if it is an out of the money put and it gets exercised, you end up buying the stock at a price lower than the current price. The only possible disadvantage is if the stock rises sharply, maybe due to a takeover offer, you lose out on potential upside.
    If there is a stock that I want to invest in, I usually try to check and see if there are options traded on it, so I can short the puts. However, I prefer to write a naked put options when the implied volatility is high.

    1. Hi Fred,

      Thanks for dropping by and it seems like we have pretty similar views when it comes to using options to make more money. When I sell the naked put options, there are more scenarios that benefits me:

      1) I get free money if the option expired worthless
      2) I get to buy the stock at a lower price (since I want to buy the stock anyway and buying it at a lower price is good)
      3) get to keep the premium for a year and make good use of it.

      For the disadvantage of the stock increasing significantly, I’ll be missing some gains, but I am sill happy as I still get free money from the premium.

  4. I like it when you cover the tax aspect of every investment idea that you presented. It gives people the option to evaluate which account is most efficient when trying to maximum the benefits of that investment.

    1. Raphael, I strongly believe that every investment endevour should have tax implication in mind if we want to keep more of the money that we make. Thank you for dropping by and sharing you thoughts.

  5. @ Leo, since you trade options, FWIW, just out of interest

    I know this is an old thread post yet I wanted to mention take a look at SVXY & UVXY which after the split & consolidate on July 17 are option candidate trades. I had been active options trader that said in retirement that I would NOT go back to it. Now my interest is back, purely for fun & speculation (since we don’t need the income) & shall be looking at trading on just these two. Over the past 12 months & in the past the volatility as well as the splits & consolidations has been an option traders dream.

    How would you trade to option both these symbols?

  6. Purely for interest purposes only – Options

    From the above, I want to say that I was an active option trader that managed to get decent returns in a short trading span where I traded options daily, sometimes within 15 minutes.

    I recently got interested again after seeing what you had been doing & also that I have followed the VIX for over 15 years.

    This week I did an option trade for options expiring 14 July 2017.

    My trade was 10 contracts on UVXY ‘in the money’ (ITM) 10.50 PUT

    On 11 July I bought to open (BTO) 10 contracts $10.50 PUT & paid $1.03/contract

    On July 13 I sold to close (STC) those contracts for $1.51

    Profit $0.48/share contract or $480 gross profit.

    Simplicity is that both the UVXY & SXVY are good options traders, especially in each the last week of their calendar date

    Of course many of the short or long expiry dates are also good providing one can get a 20% in/out with minimal investment or loss

    Covered calls, vertical spreads, so many ways to trade these two

    Next week after the splits/consolidations I may go back in to see what trade I can do for options expiring 21 July 2017

  7. @ Leo….time stamp this post. 8:45 17 July 2017

    At the open today on the following two stocks after the splits & consolidation since close on Friday 14 July

    SVXY approx $86

    UVXY approx $33

    Follow these for the next 6 to 12 months. Money to be made with options

    1. @John, I really appreciate the shout out of these investment ideas. While I will consider any opportunities that come my way, I often have to evaluate if these opportunities fit into my investment strategy/philosophy. At the current stage of my life, time is pretty much a luxury as I have many things to juggle on a daily basis. I would love to discuss these ideas with you when I have more time to get up to speed on these ideas.

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