In today's low-interest environment, you are barely earning any interest when you keep your cash sitting in a savings account. The best rate I found is with EverBank, where you get a whopping 0.91% APY (annual percentage yield) for the first year only (teaser rate for the first year). At the big banks, however, you are barely getting 0.25%. Might as well put your money under your mattress.
So what's the option (excuse my pun)? Well if you have some cash sitting idly, you can sell cash secured put options. Remember that a put option is (from Investopedia):
An option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time.
Here, the underlying security often refers to common stocks of publicly traded companies. Companies such as Apple (NASDAQ:AAPL), Intel (NASDAQ:INTC), General Electric (NYSE:GE) all have tradeable options. However, options are not just limited to publicly traded companies. They are also available on numerous ETFs ranging from index funds such as SPDR S&P 500 ETF (NYSEARCA:SPY) to commodity funds such as SPDR Gold Trust (NYSEARCA:GLD).
As the seller of a put option, you have the obligation to buy the underlying security at a specified price (the strike price) should the buyer choose to exercise his or her option. The buyer of the option will typically do so at expiration when the market value of the underlying security is below the strike price. In return, you are offered the option premium at the time of the sale.
A cash secured put is simply one where you put the cash necessary to fulfill your obligation should the buyer of the option decide to exercise it. For a strike price of $50, that means you will need to have $50 x 100 = $5000 (remember that 1 option contract equals 100 underlying shares) sitting in your brokerage account to be completely secured (we are ignoring the use of margin here for simplicity).
You can think of the option premium you collect as the "interest" on the cash you put up in your brokerage account. Using Microsoft (NASDAQ:MSFT) as an example:
- Expiration: July 20, 2012
- Days to Expiration: 79 (from May 2, 2012)
- Strike: 30
- Bid price: 0.58
- Ask price: 0.60
- Annualized return: 8.9%
For putting $3000 with the brokerage for 79 days, you get $0.58 * 100 = $58. If you can keep this up 365 days a year, then you will get an annualized return of 8.9%! Not bad compared with the 0.25% you get from the bank.
What's the risk you ask? Well, your entire $3000 might be gone. That is, if you believe Microsoft will suddenly go bust before July 20, 2012, and the stock drops all the way to 0. Even when the stock goes bust, you are still obligated to buy at the strike price.
But realistically speaking, what are the chances of Microsoft going to 0? If it does go to 0, I think there are other things we need to worry about more than the $3000 you just lost (i.e. unemployment as MSFT hires over 55,000 people in the U.S. alone).
I must stress that there are risks involved when selling a put option, but you know these risks upfront. You cannot lose more than the sum of all the individual option obligations (sum of all strike prices * 100). But if you adhere to some of the guidelines below, it will make your trades more successful, and help you sleep better at night:
Only go after stocks you don't mind owning at the price you don't mind owning it at
Since there is always a chance that your put option may be exercised at expiration, you must be prepared to own the underlying stock. This means that the most important part of selling a put option is to find the stock that you don't mind owning. Typically, I look for stable, dividend-paying companies like Procter & Gamble (NYSE:PG) and Johnson and Johnson (NYSE:JNJ). You know these guys won't be going away anytime soon unless the entire fiat system collapses on itself.
However, you can't just blindly pick strike prices after you decide on a good company. YOU must be comfortable owning the stock at the price YOU want. Even if this involves selling at a much lower strike price and receiving less premium, you will be less stressed out when the market turns against you.
Keep Commissions Low
The worst part of selling put options for income is to have part of that income taken away from you by your brokerage. Some brokerages charge a minimum fixed price + variable price based on the number of options you sell. This is especially bad for small-time investors who only sell 1 or 2 contracts at a time.
Interactive Brokers have pretty good options pricing (typically less than $1 per option with no minimum fixed price). Although you have to pay a minimum monthly subscription fee, a few option trades a month more than makes up the commission you save.
Watch the Bid-Ask Spread
The second worst part of selling put options for income is to have potential income lost due to the wide bid-ask spread. Remember that "bid" is the highest price that a buyer is willing to buy at, and "ask" is the lowest price a seller is willing to sell at. Remember that you are the seller in this case, and the bid price is the price you ultimately end up collecting. Some of the very actively traded companies like AAPL, GE, AA have very narrow spreads for near-the-money options. This means that you get a bid offer that is much closer to the asking price.
A typical ratio I use is:
(ask - bid) / ask * 100% = Bid-Ask spread percentage
The lower the value, the better. For the MSFT example above, the bid-ask spread percentage is 3.3%, which is a very narrow spread. Anything under 5% is usually very good, and over 10% should be avoided.
Focus on your goal
Set a goal for yourself and stick to it. Want to make 10% return? Then be willing to take on more risk and sell closer to the money. Happy with a 4% return? Then sell further out of the money options. Once you made up your goal and assessed your risk tolerance, stick to it.
Don't be greedy
Avoid using margin. It's tempting, but don't fall in the trap of selling more options than the amount of cash you have. If the market suddenly turns against you, you will be forced to pony up more cash or sell your options at a loss.
If you stick to the guidelines above, you should have a better chance at earning a steady return from your cash secured puts. You will also be able to sleep better at night knowing that should your put options be exercised, you will gladly take the stock off the buyer's hands.