A veteran member of my stock club who has been investing in stocks for many years told me that he has absolutely no interest in options. I respect his opinion, however, I believe that he is overlooking a very powerful tool that can be used effectively to increase income and reduce risk. In today's low interest environment, writing puts on quality dividend paying stocks may be the recipe for increasing the retirement income for those willing to learn how to harness the power of options.
When you sell (write) a cash backed put, you receive a premium because you give someone the right to sell you the stock at the strike price at any time before the expiration date. "Cashed backed" means that you have enough cash in your account to buy the stock at the strike price, if you are assigned the stock (i.e. the stock is put to you).
Selling puts on quality dividend paying stocks, such as Microsoft (MSFT), allows the option seller to get paid a premium for agreeing to buy the stock at the strike price. At-the-money puts on Microsoft produce a higher income than what dividends alone would produce. The best time to write a put is when the stock has sold off, such as Microsoft has done recently, since a good portion of the downside risk has already been taken out of the stock.
Microsoft Short Term Price Chart
The short term chart shows that recently Microsoft has oscillated in a range from slightly under $29 to about $31.50 and that it is currently trading at the lower part of the range.
Put Option Strategy for Microsoft
When the stock has sold off, it is a good time to consider writing puts. I expect Microsoft to cycle up to the upper part of the price range within the next few months. Friday October 12, Microsoft was selling for $29.10. A November 17, 2012 put pays a $.76 premium. This put option has 36 days until expiration. The $.76 premium is more than three times the quarterly dividend of $.23 for a put option that expires in 36 days. From my perspective, writing this put option entails three times the reward for one third the risk as compared to just buying the stock for its dividend.
What are the risks associate with the strategy? Let's assume that the market or stockholders push Microsoft below the $29 strike price. If this were to occur, you would get assigned the stock and be required to buy it at $29. Your paper loss is still smaller than if you had bought the stock because you have been paid the option premium. Being assigned a high quality dividend paying stock is not a bad result if you believe in the long term success of Microsoft, and you got in at a good entry price. I believe that Microsoft will continue paying and increasing dividends, is currently at a good entry price, and will not stay down for long.