Volatility Makes This Income Strategy Even More Profitable
They say that every challenge can be viewed as an opportunity. Nowhere is that statement truer than in the options market. You see, option contracts thrive during periods that wind up being very challenging for traditional stock traders and investors. And there is a logical reason for this.
Why Options Thrive on Uncertainty
To understand the relationship between uncertainty and option contracts, we first have to take a quick look at what options really are. There are two primary types of option contracts available to traders:
Call options: A security that gives the buyer the right but not the obligation to buy a stock at a specific price for a limited period of time.
Put options: A security that gives the buyer the right but not the obligation to sell a stock at a specific price for a limited period of time.
Let’s think about the value of these contracts.
If an underlying stock is trading in a very tame price pattern (with only minor fluctuations), then neither a call option nor a put option would be worth much. This is because your expectation of a dramatic movement in price is low. So you wouldn’t want to pay a significant premium for the ability to buy or sell stock at one specific price.
On the other hand, if an underlying stock fluctuates wildly, the value of an option contract should be much higher. For instance, owning a call option that gives me the right to buy a volatile stock at $35 could be very valuable if there is a chance that the stock will trade up to $60 before the call expires. Even if the stock is currently trading at $33, that call option is valuable for a stock that has a huge amount of potential, i.e., volatility.
The same dynamic works for put options. This is because a tame stock is unlikely to fall dramatically in price. So the value of a contract that allows you to sell the stock at a specified price isn’t all that attractive. When prices are more volatile, put contracts have move value because there is a much greater chance that a stock will fall significantly.
If I own a put contract that allows me to sell a stock at $50, and the underlying stock price drops to $20, that contract is actually worth $30 per share. This is because I can buy the shares in the open market at $20, turn around and sell them with my put contract at $50, and book a $30 profit on the trade.
The bottom line is that higher volatility leads to higher option prices. While volatility can wreak havoc on a typical portfolio of stocks, it can be used to generate very attractive income for traders with a little more creativity.
Falling Prices, Put Premiums and Underlying Bids
One of the best ways to benefit from a volatile market is to sell puts against stocks that you already have an interest in owning. With a put selling strategy, the volatility associated with falling prices works to our advantage by giving us income and offering us a chance to buy some of our favorite stocks at a discount to current prices.
As a general rule, falling prices are associated with higher volatility premiums for option contracts. This is because investors are typically comfortable with advancing markets. Rising stock prices are considered “normal,” and investors are usually happy to continue holding stocks that are rising.
But when stocks are falling, investors are typically unsettled and compulsive. As prices decline, investors panic and add to the selling pressure. Ironically, when prices start to stabilize, investors can panic, fearing that they now don’t have enough exposure, and send stocks sharply higher. Then more fundamental weakness is discovered and the sell-off begins again.
All of this volatility creates more opportunity for option traders. There is more embedded value in owning both calls and puts, because the price of underlying stocks can fluctuate in either direction very quickly. This leads to higher option prices as traders take advantage of the volatility.
Higher put prices allow us to generate even more income with a put selling strategy and have a shot at buying our favorite stocks at a discount price.
If you’re like me, you keep a list of quality stocks that you would like to own at some point. Often these stocks trade at prices that are just a bit higher than I am comfortable paying, although I would like to own the company at a lower price point.
When a stock’s price falls (due to a market correction, a short-term pullback, a weak report from a competitor, etc.), we can sell puts that give us the obligation to buy the stock at a particular price, known as the strike price. Typically, I like to sell put contracts with a strike price just a bit below the current price of the stock.
Remember, since volatility has picked up, prices for the put options will naturally increase. Since we are selling these put options, we are able to capture the benefit from the higher put prices.
If the underlying stock recovers quickly, our obligation will not kick in. For situations like this, we simply get to keep the premium that we received for selling the puts in the first place. This gives us income that we would not have otherwise earned from our cash balance.
On the other hand, if the stock falls a bit more and stays below the strike price when the puts expire, we will be obligated to buy the stock. Remember, this is a stock that we want to own, and one that we have been waiting for lower prices to take a position in. Now, we are not only able to purchase the stock at the price we wanted, but we have also been able to collect income for accepting the obligation to buy it.
As you can see, volatility doesn’t have to be a source of frustration for us as investors. The next time a stock on your watch list dips lower, consider checking out the put contracts for an opportunity to collect income and potentially buy at an even better discount.
Note: By using this income-generating strategy, my colleague, Amber Hestla, has helped her Income Trader members earn $6,000… $19,500… even $150,000 this year alone. Click here to learn how you could do the same.