Option Writing For Passive Income Part Two

Back in August, I wrote about making passive income by selling cash backed naked puts. If you haven't read that post, I suggest you first go back and do that now. After four months of doing this, I thought I'd post about how it's going so far.

I made four trades total, each time selling 5 or 6 contracts with an expiration date three to four weeks out. Details of three of those trades can be found at these two posts. The fourth trade ended the day I am writing this (Dec. 15) when the options expired out of the money. Last week, Realty Income stock dropped and I thought there was a pretty good chance I would be called and have to buy the stock. However, the stock rallied 2 points this week to close at just over $57. My $55 options expired out of the money. This investment netted me a 9.11% annualized ROI. 

Compare This To Straight Out Buying The Stock 

The total amount of money I have received from trading naked puts since August is $899.70. How does this compare to if I had just bought the shares outright?

I sold my first puts on August 10. At that time, I sold 5 contracts, which translates to 500 shares. My other three trades were for 6 contracts, or 600 shares. So for this comparison, let's assume I bought 500 shares on August 10 and another 100 shares when I sold my second put - October 6.

Realty Income also pays a monthly dividend. If I owned the stock, I would have received this money, but, as an option writer, I do not. Furthermore, the company also raised the dividend during this period. So this comparison needs to include any dividends I might have received. (For the sake of simplicity, I'm going to assume I would not have reinvested the dividends and instead just took them as cash.)

The closing price for the stock on August 10 was $57.02. This would have been my cost to buy 500 shares. The closing price on October 6 was $56.48. This would be been my cost to buy an additional 100 shares, bringing my total shares to 600.

Had I bought the shares outright, my total gain would have been any price appreciation of the stock between when I purchased it and today plus any dividends received. Since my last batch of options expired today, we'll take today's closing price of $57.40 as a sell price for this comparison. My options figures include commissions, so we'll also take those into account for the stock purchase scenario.

Here are two tables showing the calculations. This first shows gains from the stock price going up. A negative price indicates a purchase, a positive price, a sale. The second table shows the dividends I would have received. The Dividend Record Date is the date I have to own the stock in order to be eligible to receive the dividend. The Dividend Payment Date is when the dividend is paid.

A Hefty Increase

As you can see, had I bought the stock outright, I would have made $733.30.

By selling naked puts, I earned $899.70.

I made 23% more by selling naked puts!

It Gets Better

And let's look at this another way to see how it can get even better. Assume the stock closed below the option strike price ($55) today and my options were called. I would be forced to buy the stock at $55. But don't forget, I've already been paid $0.40 per share to sell the option in the first place. Now let's also take into account the money I received from the previous three times I sold puts that were NOT called ($.55, $0.30, and $0.40 per share), that means I've already received a total of $1.65 per share. So if I had to buy today at the option price of $55, my actual net cost would be $55 - $1.65 or $53.35 per share. That means I would only have lost money if the stock closed below $53.35 per share. That's quite a bit of downside protection built in!

The more astute of you will realize that the more times I sell puts that are not called, the greater my downside protection becomes.

What's The Catch?

So why doesn't everyone do this? That's a good question. My overall profit was helped by one big factor - my options were never called. I was never forced to exercise the options, so I maximized my investment. I'd like to think this is because I'm a fantastic stock picker, but I'm not. In the long run, no one is. I happen to know this stock fairly well because it's been my main investment for over a decade.

The market is still volatile and things could have gone differently. If the the stock experienced a rally, I would have missed out on it. The price could have dropped a lot and I might have been forced to buy at a price over market value.

But here's the thing: I'm completely OK with my options being called. I wouldn't mind paying slightly over market value for this stock. Obviously, I would prefer my options are not called - I'll take that extra 23%, thank you very much - but I like the underlying stock and I would have no problems owning it. So this is pretty much a risk-free investment for me: If the options aren't called, I keep the money and do it again the following month. If they are called, I buy the stock and hold on to it. I'm happy either way.

I'm trading earning extra cash and getting a higher ROI now for the possibility of missing out on a big price increase. By only selling options with 3 or 4 weeks until they expire, I'm also minimizing this risk somewhat.

Make Some Extra Cash Before You Buy

Not everyone is in my position. This won't be a suitable investment strategy for many people. However, if there is a stock you are looking to buy, it might be worth your while to investigate this investment tactic as a way to pick up some extra cash as you buy the stock.