Selling Options for Cash Flow
Using options for short term income
Let’s be honest, most people are in the markets for one reason: to make a profit. Whether looking for long-term investment goals, or short-term income goals, we’re looking to grow our accounts with as little risk as possible.
Now for most traders and investors, that entails being right directionally. Needing an asset to move in a specific direction to profit, while taking on risk if the trade goes against us.
Now while there’s no such thing as a risk-free trade, and any trade can go against us for any reason, there is a way to use assets that we either already own, or are just willing to own, as collateral, so to speak, to generate steady cash flow without even needing to be right on the expected directional move of the asset.
Options are unique among assets in that options are the only asset that has any value above and beyond its intrinsic value. Because options have an expiration date, the premium of the option also includes the time value remaining until the expiration date. So, when we buy or sell options we’re also buying or selling the time value as well as the intrinsic value.
Today, we’ll talk about selling the time value to generate cash flow on a regular basis. Now some options are intrinsically worthless, which means the premium on those options consists of only the time value. So, when the option expires, which it will, if the option still only consists of time value, it will expire worthless, and we get to keep the premium we collected when we sold it.
When selling options, we take on obligations to either buy or sell shares of stock. When selling put options we take on an obligation to buy shares of a stock, and when we sell call options, we take on an obligation to sell shares of a stock. Just like an insurance company that sells you a car insurance policy. They take on an obligation to pay out on a claim if you crash the car, and they get to keep the premium you paid if you don’t have an accident.
Today, most equity options have weekly expiration dates expiring every Friday, with some ETF’s even having expiration dates three times every week! This means that we can sell options, we can sell calls or puts, collect the premium from the sale, and keep the premium we collected when we sold if the options expire worthless on expiration day.
Now the trick is to not only understand the mechanics of how the options work, but to understand where we believe the stock won’t go by the expiration date. As I mentioned earlier, most traders profit on where a stock goes to, to a profit target. But when selling options, we can profit based on where a stock doesn’t go. We’re not selling the options intrinsic value, as we have no idea if the stock will get to our profit target.
What we’re selling is the options time value. We’re literally selling for money!
Say an option expires next Friday, 12/9? Now I have no idea where the stock will be on 12/9, if I knew that I wouldn’t be sitting here writing to you! But I can guarantee that 12/9 will get here, and if the stock doesn’t go where we don’t think it will get to, the option will expire worthless, and we get to keep the premium. Yes, just like the insurance company, we took on the risk of having to fulfill an obligation, but also like the insurance company, we’ll do our due diligence to assess that risk before entering the trade.
So, while the insurance company will ask for your driving record, before issuing you an auto policy, or your medical history before issuing you a life insurance policy, we’ll assess, using the Pinnacle Method of supply & demand, where we believe a stock won’t go, thus allowing the options we sold to expire worthless.
Of course, there’s risk of assignment, the risk we took on when we sold the options and collected the premium. The obligation we might have to buy or short the shares. So, position sizing, and appropriate risk management are essential, as always to protect our principle, and minimize loss as much as possible if the trade goes against us.
But if done correctly, the selling of options can be a very successful way to generate weekly or monthly cash flow.
Please reach out to Pinnacle for more information on how to trade options, or to learn more about supply and demand.
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If you enjoyed this article and would like to learn more about options, click the following link to our Options 101 video on YouTube:
Trading Options with Supply and Demand. Options 101 with Steve Moses – YouTube