The Risks of Writing OTM Options

In an earlier post, entitled Generate More Income From Dividend Stocks, I discussed some simple option strategies to generate additional income, which involves writing out-of-the-money (OTM) put and call contracts. This post delves a bit more into the details of these strategies about how market conditions can favor or play havoc on the contract writer. I discuss details below on when not to use these strategies and the some of the disadvantages of these strategies.
The recent downturn in the market has revealed a lot of option strategists out there getting caught with their pants down. Over the last couple of years, we have experienced a tremendous run in the stock market. The year 2013 turned out to be one of the the best performing years in recent history, all thanks to the Fed keeping low interest rates, flushing the economy with cheap money and buying bonds, thus bolstering the stock market. Investors have been encouraged to take on risk and have been rewarded; But when times are good, bad things arent as obvious as normally should be.
Writing OTM Put Contracts
Writing OTM put contracts provides the writer with options income and works great as a strategy in secular bull markets. The writer is only obligated to buy the underlying security if the stock falls below the strike price. This is the situation that a lot of people have been caught in recently during the ongoing correction. Option writers have had to buy back the put contracts to minimize the loss.
Writing put contracts should not a strategy for the weak-at-heart trader. A company’s success and a rising stock requires a lot of hard work and it only takes a little stumble for the stock to come crashing  down. Remember that a stock never crashes up, it always crashes down. In addition, some other uncontrollable events may throw a wrench in an option writer’s strategy such as – an analyst downgrade, political conflict, threat of war or recession or simply the fact that a stock belongs to an index and there is a broad market selloff.
Writing OTM Call Contracts
Writing OTM covered call options provides the writer with options income and the writer only needs to sell the underlying security if the stock closes above the strike price. While this can be a good strategy in a sideways or bear market, this strategy does not work too well for the writer in situations such as: secular bull markets or rapidly rising stock values, analyst upgrades, positive earnings catalysts etc.
The other major problem with this strategy is that you are obligated to sell your shares for a company that is doing well and limits your upside potential for returns.

Generate More Income From Dividend Stocks

Option strategies can act as a complementary method for boosting your portfolio returns. The best dividend stocks in the market yield approximately 2-3% and the dividend growers growers tend to increase their dividends year after year giving you a pay raise for simply holding the stock. Some dividend stocks may yield higher (3-6%) but may not necessarily increase their dividends year after year. To generate a high revenue stream to live off the dividends from your holdings requires a huge portfolio when high quality stocks pay 2-3%. Lucky for us, there are simple options strategies that we can use to supplement our income and boost our returns. This post requires a basic knowledge of options trading. The strategy covered are writing out-of-the-money (OTM) put and call options.

Using these simple options strategies, you can generate more income in your portfolio leveraging the dividend stocks. The option strategies discussed here are not limited to dividend stocks and can be applied to any optionable security. Note that options trading is extremely risky and because these are leveraged trades, the losses can be substantial. Always make sure you fully understand the trade and how it works before you start trading.

Writing out-of-the-money put contracts

If you want to initiate or add positions on a stock, write OTM put contract. You collect the premium for the option that you wrote; and If the stock stays above the strike price, you simply keep the premium and it expires with no obligations. If the stock price drops below the strike price and the option is called, you buy the stock at the contract price and add to your position of the dividend stock. Your average stock price goes down below the strike price when you factor the collected premium.

Writing out-of-the-money covered calls

If you own the stock, you could write OTM calls on the dividend stocks you own. If the stock price stays below the strike price, you simply collected the premium and have thus generated income in your portfolio without any other obligations. If the stock rises above the strike price and is called, you sell the stock at a profit. Of course, you should be willing to sell these shares of the stock from your portfolio if the option is called.
These are short positions and these trades are called sell-to-open (STO). So, you are opening a trade by selling and when you intend to close the trade, you buy-to-close (BTC) or wait for the options to expire.

ETFs

There are plenty of ETFs which uses this strategy to generate monthly income with yields as high as 8%. For a detailed look at this category, check coveredcalletfs.com

A note for Canadian residents

The government of Canada, in its infinite wisdom, allows its residents to only trade long positions (BTO and STC) and shorting covered calls (STO) in registered accounts such as RRSP and TFSA. If you want to STO puts, you will need a non-registered account. How the government justifies this, is beyond me!
Have you tried these trades to boost your income? What are your thoughts?Image Credit: Stuart Miles/freedigitalphotos.net

 
Disclaimer: The information provided here is for educational purposes only. All opinions here are my personal opinions and should not be taken as financial advice. I am not qualified to be a financial advisor. Always consult with your financial advisor before investing in any of the companies mentioned on this blog.