How to Up Your Income Flow
Some stocks just do not grab the imagination.
There is no exciting China strategy to unfold. No game-changing piece of technology set to disrupt the market.
The stock price simply follows the rest of the market, meandering from year to year. Results announcements come and go, barely rating a mention.
They are the kind of stock that never turn up on a ‘Five best stock ideas’ list for the year ahead.
Sometimes, though, these stocks are not as dull as they might seem.
Not because their share price might suddenly burst higher. Instead, it is something much more basic. That is, the amount of income they could help you generate.
It’s not about sitting back and collecting dividends. Although dividends, of course, always come in handy.
Nor taking up a dividend re-investment plan (DRP), if the company offers one. Although this too can help grow your wealth exponentially over time.
These boring old stocks, that virtually do nothing, can form the basis of a multiple income strategy.
How does it work?
Let’s say you own shares in a company that pays a dividend every six months. You know that unless something dramatic happens to the stock, you can expect to receive two dividends year after year.
One way to generate an extra lot of income beyond dividends is to write (sell) call options. By writing a call option, you are agreeing to hand over these shares at the option’s strike price, if the buyer exercises the option.
To compensate you for this obligation you are taking on, you receive a premium.
If the share price spikes above the option’s strike price, however, you could miss out on some potentially big profits.
It is a calculated risk. You need to weigh up the probability that a share price could jump, especially on a stock that rarely moves around much at all.
By writing an option above the current share price, you are potentially gaining two things. First, you receive premium into your trading account.
And second, if exercised, you will be selling your shares higher than the current market price.
How about another leg?
Collecting dividends and writing call options can really help ratchet up your income. If you get your timing right, writing call options could double the income (or more) from collecting dividends.
However, there is also another way to add to the income haul. That is, by writing (selling) put options.
Writing a put option is the opposite to writing a call option. As we have discussed, writing a call option obligates you to hand shares over if exercised.
When you write a put option, however, it obligates you to buy the underlying shares. Meaning that you have to buy the shares at the option’s strike price.
By writing a put option below the current market price, you are also achieving two things. First, as with the call option, you are collecting premium income.
The second thing is, that if exercised, you will be buying shares below the current market price.
So how do you put the strategy together?
The basis of this strategy is that you must own the underlying shares. If you write call options over shares that you don’t own, you could leave yourself open to potentially large losses.
That’s because if you write a call option (and it is exercised), and you don’t own the underlying shares, you will have to go out and buy them in the market to fulfil your obligations.
Not only is it stressful, but your broker will charge you extra for all the hassle.
By owning the underlying shares, you can hand them over if exercised. Plus, as I mentioned above, by owning the shares, it entitles you to any upcoming dividends.
So how does the third leg fit in?
By writing a put option, you are agreeing to buy the underlying shares if exercised. As I say, though, at a lower level than the current market price. Plus, you collect a premium when you write the put option.
The important thing being that you only write the put option at a level you are happy to buy the shares.
As you can see, this strategy enables you to collect two option premiums on top of regular dividends. The written put, and the written call.
If the share price does nothing, you can keep both options until they expire, and look to write another lot of options after that. Alternatively, you can buy the options back early, and then write more options for an earlier lot of additional income.
As always, though, you must understand any risks and obligations you are taking on. If the share price tanks, not only do your existing shares fall, but you will also add another lot of shares to your holdings if the buyer exercises their put option.
And as we covered, you could miss out on potential profits if the share price rallies and the buyer exercises the call option.
However, in a range-bound market, on shares that don’t really move around much at all, writing both call and put options can really help boost your income flow.
All the best,
Editor, Options Trader
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