Yes, I made 72.8% or $7,290 last year trading options. You can do this too. It takes very little time, is less risky than owning stocks without a hedge, and you can learn while you earn.
I trade options on a small portion of my portfolio.
I keep a three-pronged portfolio:
- Risk-free assets – 10%
- Core holdings – 80%
- Alternative investments (trading options) – 10%
The percentages change slightly with each investment but the strategy stays the same. For example, you may want to allocate 30% to risk-free, 55% to core holding, and 15% to Alt investments. I’m one of the people who believes in an aggressive stock/bond allocation by age for most people. For those wishing to add a little spice to their stock / bond mix, alternatives are a great way to accomplish this.
#1 – Risk-free assets:
Ahhh…risk-free assets. They allow you to sleep at night. No market risk, interest rate risk, liquidity risk, or credit risk. Risk-free: This is really just a theoretical rate of an investment with no risk. Most investors use the 3-month T-bill as a benchmark for the risk free rate.
That’s most investors. I’m different. I use the 2-year Treasury Note. That’s what I shoot for as my risk-free rate. The 2-year Treasury Note is currently yielding 1.2%
My risk-free holdings include cash (a negative return!), Treasuries, and Certificates of Deposit. My goal here is simple: just try to earn around the same as the current two-year Treasury.
#2 – Core Holdings:
I keep a core holdings that includes individuals stocks and ETFs. My goal with this portion of my portfolio is to get a 9-12% yield while being diversified across many sectors of the market. I like stocks with growing dividend yields and small appreciation. I also like stocks with no dividends that have really good growth prospects but are currently undervalued. You could set up your core holdings to include ETFs, Index Funds, even – dare I say – mutual funds.
#3 – Alternative Investments:
The alternative investments portion of my portfolio is where I trade options. I consider an alternative investment to be anything other than traditional stocks and bonds. This could be options, crowd-sourced RE, metals, commodities, P2P, private equity, timber, RE flips, and any other non-traditional investment. My goal with the alternative investments portion of my portfolio is to achieve at least 25% CAGR.
Making Money Trading Options
You can see that we’re not trading options with our entire portfolio. Stay disciplined. Stay properly allocated. I’m trading options with a small portion of my portfolio. This is tracked separately in my alternative investments account.
Here’s my strategy:
#1 – Pick a few stocks you wouldn’t mind owning or holding for at least a year.
#2 – These stocks should have higher than average volatility because you’ll be selling call and/or put options.
#3 – Buy 100-share increments of the stock that represents the best opportunity at the time. You shouldn’t buy an entire position at once in most cases. Instead, leg into your full position in 2-3 legs.
#4 – Sell call options against the stock you’re holding with expiration dates less than a month out. I sometimes do a week or two weeks out if I can get decent premiums. The reason being that I want my options to decay quickly and become worth less. As options approach their expiration date, the amount that time makes up the value of the option (theta) decreases exponentially.
#5 – If the price of the underlying security goes down, I buy more and sell options against it. Sometimes I will buy back a current option and roll down to a lower strike price to get larger premiums.
#6 – If the price of the underlying security goes up, I do nothing (which is my favorite thing to do).
#7 – If the price of the underlying security stays the same, I still do nothing most of the time. Sometimes I’ll add more to the position and sell more covered calls against what I own
#8 – The strike price I’m selling call options for is usually just a little higher than the cost basis on my shares (e.g. If I buy shares at 29.72 cost basis, I usually sell options at the $30 strike price).
#9 – Then it’s just a matter of being patient and letting options expire or having your stock called away so you can do it again…and again.
#10 – While this strategy involves a decent amount of trading, it doesn’t take that much time. You can place limit orders on weekends and not even worry about it. You’ll be notified via email when your trade is executed. The biggest time commitment is figuring out which stocks to use.
I added the following stocks to my watchlist at the beginning of last year to use this strategy:
- Whole Foods Market (WFM)
- United States Oil Fund LP (USO)
I picked both Whole Foods and USO because they both got beat up a lot, have a higher than average volatility, and I wouldn’t mind owning them both long term. I stay away from stocks in industries which are in secular decline and have no chance of turning around.
And guess what: You can use these same stocks / ETFs in 2017. The underlying fundamentals haven’t budged.
The first trade I made in 2016 was to sell 6 covered call options on the 600 shares of Whole Food I had owned since late 2015.
Trade #1: I already owned 600 shares of Whole Foods at a cost basis of $29.36 from November 2015. I built this position with two separate trades as you can see below. I purchased 400 shares at $29.56 and then another 200 as the stock dropped to $28.99.
The 1st options trade I made in 2017 was to sell 6 covered call options at $0.60 per option that expire on January 8th at a $33 strike price for a total premium paid to me of $346.29.
The reason my cost basis is $29.36 and the strike price of the call option is $33 is due to the run up on Whole Foods stock in December 2015 as shown below.
And yes, I was selling call options against WFM shares late in the year too, but my shares were never called away. I kept holding as the stock ran up late in the year but the focus of this article is simply on 2016.
As of January, I was sitting on unrealized capital gains of $1,092 plus just sold 6 call options to collect $346.29.
Three days after I sold the call options I bought them back (buy-to-close or BTC for all you home gamers) for $0.30 per contract giving me a short-term realized net gain of $157.04.
Why buy them back so soon? I normally wouldn’t buy back options after only a few days, but in the case the stock was dropping quickly and I saw an opportunity to lock in a gain and make another trade.
Trade #2: The second trade was a roll down trade. I went from buying back a strike of $33 to selling a strike of $32. I sold 6 covered call options at $0.60 per option that expire on January 15th at a $32 strike price for a total premium paid to me of $334.29.
The reason you want to roll down is that you get a higher premium for a more in-the-money stock (ITM). It makes sense to do this when your underlying security is dropping. And Whole Foods continued to drop so I bought back the call options to close at $0.10 per contract for a short-term net realized gain of $265.09.
Whole Foods continued to slide in January 2016 getting back to my original cost basis so I purchased another 200 shares.
Source: Google Finance
Trade #3: After purchasing the additional 200 shares, I sold 8 covered call options with a $29.50 strike price expiring January 22nd for $0.25 per contract for a net premium paid to me of $189.66.
My 800 shares were called away on January 22nd at $29.50 a share. As you can see from the chart above, WFM traded above $30 on January 22nd. I got to keep my premium of $189.66 and made a small gain when the shares were called away.
I was paid $611.79 in net premiums for writing the options against Whole Foods in January and even made a small amount of short-term capital gains.
Goodbye Whole Foods, Hello Oil
Oil got more than cut in half from its high in 2015 as you can see on this chart from 2015-2016.
Any asset that drops by 50% is immediately on my radar. I couldn’t wait to start buying oil in January of 2016. I had to wait until my Whole Foods position was sold. Oil represented a better opportunity at the time (don’t get jealous Whole Foods; I’ll buy you again later in the year). The price was at decade-year lows and the premiums on options were high. I decided to switch to writing covered calls on oil.
Oil Trade #1: I purchased 1,000 shares of USO at $9.06 a share for a total cost $9,068.25 on 2/1/16. I simultaneously sold 10 covered call options at the $9 strike price expiring on 2/5/16 at $0.33 per contract, collecting a total premium of $313.14.
I used the strike price of $9 instead of $9.50. The reason: The $9.50 strike wasn’t paying anything for a week out. You could use the $9.50 strike if you go a month out or longer.
I lose money on the underlying security if USO trades above $9 per share because it will be called away at $9 and by cost basis is $9.06. I’m okay with this scenario because I make much more on the option premium. This trade would net a gain of about $240 after commissions if the price of USO is at or above $9. That represents a 2.6% return in about a week. That’s a 135% annualized return.
What actually happened on this trade?
Take a look at the snapshot below:
The stock price of USO dropped to below $9 and I got to keep the $313 and my USO shares.
USO Trade #2: I then bought 400 more shares (remember, we leg into these trades) at $8.34 a share for a total cost of $3,344.95. Now I hold 1,400 shares at an average cost basis of $8.87. I’ve already made $313 and now I’ll write another call option. I sell 14 options at a strike of $8.50 expiring on 2/19/16 at $0.30 per contract for a total premium paid to me of $399.97.
I bought these options to close on the day they were set to expire for $0.03 an option netting $0.27 per option and I still hold onto my position in USO. They would have expired and my been called away but I prefer to close out a position if it gets close to zero. If you’re under $0.05 per contract then buy the call back. No need to hold on for a few extra cents when you can lock in a gain and write another call option farther out on the calendar.
USO Trade #3: I sell another 14 call options at the $9 strike expiring on 2/26/16. Notice how I roll up to the $9 strike and roll out just a week. My cost basis on this 1,400 shares is $8.87 so I’d ideally like to have them called away above that price. If not, it’s not big deal. You still make money on the option premium side of the trade.
I continued to trade oil and options as the price of oil rose during the first half:
I’d sell call options when USO dipped and buy them back when USO dropped. Oil trades erratically. It’s up one day and down the next. Sometimes there’s a reason (OPEC meeting, crude inventory levels). Sometimes there’s not one. I have no idea what oil is going to do next month or next year. I just know if I trade options against shares that I own, I’ll make money over the long term.
Know When To Fold Em’
It’s sometimes hard to know when you’ve had a good run trading options on one stock and should move to another. The longer you practice trading options, the better you’ll feel about what to do and when to do it.
I folded on USO before summer after it hit something like $12 per share. I realized it could drop back down to $8 and that drop would be too big to have options premiums make up for it. Trading covered call options works best in a flat to slightly bullish market, in this case I’m referring to oil market.
I switched back to trading Whole Foods covered call options in April:
Then back to trading options on USO in August:
See how USO came back down to below $10 / share? It represents a better opportunity at below $10 per share than anything else I could find.
If I would have simply held USO from 1/1/16 – 12/31/16, my return would be 6.55% for the year. That’s okay but it’s a pittance compared to the returns you could generate by trading options.
Source: Google Finance
Lessons I’ve Learned Trading Options For Over A Decade
#1 – Start slow and with a conservative options trading strategy like covered calls or cash-secured put options.
#2 – The stock you buy will go down by more than the options premium you receive. This is to be expected and keeping a long-term view is key. You’ll be in the green if you follow a good strategy.
#3 – Don’t trade stocks that you wouldn’t be happy owning for the long haul.
#4 – Keep your options trading to a small portion of your portfolio. Breaking your portfolio out into 3 separate categories is a great way to compartmentalize your investing.
#5 – You’re not likely to get rich trading options. You can make a 1000% return on your money if you take one side of a trade. You’re just as likely to lose all your money in these situations so be careful with your position size.
I was able to generate returns by following the strategy I laid out in this post. Week after week and month after month of following this strategy resulted in a 72.9% annual gain on an average $10,000. I didn’t have to spend too much time researching stocks and trying to figuring out what to buy. Your timing doesn’t have to be perfectly right. You can afford to buy a stock a little high and have it come down.
I’d like to know your results if you’ve traded options recently. Just sign up in the form below and reply back to the intro email. Make sure to put “Options Trading” in the subject line. Look forward to hearing from you.