For the last few months I studied options.
(Thanks in part to Dutch Independence for answering a lot of my questions and publishing lots of great content about options.)
And although option trading can be a risky thing, I'm confident I can use it to generate some nice extra income. Which I will then obviously reinvest in dividend growth stocks.
In this blogpost I will tell you some of my thoughts and reasoning.
As a dividend growth investor, my goal is to eventually live off of dividend income.
In order to get that dividend income, I need to build a large portfolio of dividend paying stocks. I do that by regularly buying shares of world-class businesses that have a history of paying increasing dividends.
When I buy those shares, I don't mindlessly buy something. I'm only buying stocks that are undervalued at that moment. In other words, I want to get a good entry price.
Well, that's exactly what options can do for me.
But first, let's take a quick look what an option really is.
An option is a contract between two parties.
One party gains the right to buy (known as a 'call') or sell (known as a 'put') something at an agreed upon price, before or at an agreed upon date.
The other party has the obligation to sell (or buy) that something to the first party for the agreed upon price, if the first party decides to exercise the option.
The party that got the right pays an amount of money to the party that got the obligation. This is known as the 'option premium'. It's basically compensation for taking on the obligation.
If the option doesn't get assigned, the party that took on the obligation still gets to keep the option premium.
Easy, right?
Nah.. Just kidding. If you don't quite understand options yet, don't worry. It's a difficult concept and it also took me several weeks to really understand how everything worked.
So, remember how I said I want to get a good entry price on my stock purchases?
Well, that's what I can accomplish with options.
Let me show you with an example:
I own 63 shares of Intel (INTC), and I wouldn't mind owning more.
Shares of Intel currently trade for $47.41. I could sell an option on Intel with a strike price of $43 (the price I would like to pay) and an expiration date of about 45 days from now. By selling that option I gain an option premium of $52 and an obligation to buy 100 shares (1 option contract consists of 100 shares) of Intel at $43 per share (if the option gets exercised).
One of two things can now happen:
- The share price stays above $43 and the option will expire worthless
- The share price goes below $43 and I have to buy 100 shares at $43
I'm fine with either of those two. And regardless of which one it is, I get to keep that option premium of $52.
Think about it. Worst case scenario is I buy shares of Intel at $43 per share (which I want!). And if the option doesn't get exercised, I still get to keep the option premium. Win win!
Instead of just waiting for the share price to drop, I'm basically getting paid to wait.
So, let's get back to my strategy.
At any one moment in time there are a dozen or so stocks that are, in my opinion, undervalued (based on fundamental analysis).
But I don't always have the cash to buy shares of those companies.
That's when I will sell an option.
My plan is to sell put options on those stocks, to gain option premiums and the obligation to potentially buy those shares at a good price. This gives me a nice stream of extra income I can use to invest in dividend growth stocks.
Now, you may ask, isn't that risky??
Not necessarily.
Because here's where things get really interesting:
About 95% of options expire worthless.
They don't get exercised. Meaning the party that took on the obligation (me) gets to keep the option premium without doing anything in return.
Why they don't get exercised, you ask? Well, because the share price didn't go below the strike price. And why would someone sell shares for $10 to me when they can sell them for $15 on the market?
That means I get a lot of option premiums, without doing anything in return. And in the odd case where I do get assigned, I buy shares for a price I like.
Conclusion
By selling options, I can generate a nice stream of some extra income, and potentially buy shares for a price that I would really like.
I'm planning on writing a bunch of updates on my option selling adventures, so stay tuned!
In the meantime, you can see all my option trades in real-time on my options page.
I will also include the income I earn from selling options in my monthly dividend income updates, starting with August's update.
What do you think? Have you ever considered options as well? Why or why not? Let me know in the comments. I would love to hear your thoughts.
Disclaimer: I am NOT a registered investment advisor, financial advisor or tax professional. Any information found on this website is not a substitute for professional advice. This website should be viewed for entertainment purposes only. No guarantees or promises are made regarding the accuracy, reliability or completeness of the information presented. Please consult with an appropriate professional before investing any of your money.