Options Income Series – Earn Double-Digit Income (Feb. 2023)

Earning a decent income from your investments that’s significantly higher than the rate of inflation is always challenging. This has been especially true in the past decade and a half. We believe selling Options (cash-covered puts and covered calls) remain a relatively good choice to earn a high income. However, certainly, there are some risks involved with Options, and we will discuss how to mitigate them in a bit. In the current volatile market situation, we will urge extra caution and due diligence.

If you’re a conservative income investor, always select dividend-paying stocks (to write options) that you are willing to hold at least for a period of one to two years if you had to. Always keep an extra margin of safety, and don’t take the risk that you cannot afford. That said, regarding Options income, an ideal market would be a rising or steady market for PUT options and a stagnant or flat market for CALL options. For PUT options, we should choose stocks from sectors that are currently favored. Also, these stocks should display a high level of relative strength. For CALL options, we should select stocks that offer highly reliable and safe dividends besides being able to grow their earnings in good times and bad.

“Selling Options” Versus “Buying Options”

Please note that the options strategies discussed in this monthly series are limited to selling (or writing) the Covered Call options and cash-covered PUT options. We do not cover “buying” the Options as they’re not only risky, but at the same time, they’re not really suited for income strategies. The primary purpose of our options strategies is to generate income. As such, there are two sides to options. There’s an option buyer for every seller of an option. When you sell an option, you earn an immediate premium, and you get to keep that premium irrespective of the outcome of the option. However, when you buy an option, you pay the premium upfront and basically buy the right to buy (or sell) the underlying security at a pre-set price (called the strike price). As an option buyer, you’re essentially looking for a high gain, but your entire investment (the amount of premium paid) is at risk if the option expires worthless, which, by the way, happens the majority of the time. We believe the strategy of selling options (opposite of buying options) to generate income is the safer strategy. It’s more akin to acting like an insurance provider, where you earn the premium upfront, and if you act conservatively, 80%-90% of options should expire worthless, thereby limiting your risk.

Author’s Note: This article is part of our periodic series that attempts to present three lists of stocks that could be suitable for writing options to generate safe income. Certain parts of the introduction, definitions, and section describing the selection process may have some commonality and repetitiveness with our other articles in the series. This is unavoidable as well as intentional to keep the entire series consistent and easy to follow for new readers. Regular readers who follow the series from month to month could skip such sections.

All tables in this article have been created by the author (unless explicitly specified). Most of the data in this article are sourced from Fidelity, Yahoo Finance, DripInvesting, and Barchart.com.

How To Mitigate The Risks

We do not intend to convey an impression, especially to the folks who are new to options, that there’s no risk in selling options. In fact, there’s plenty, especially if we’re not careful. However, there are ways we can minimize the risk by following certain time-tested principles.

• The first rule is that we should not use the margin (or borrowed) money to write or sell options. That should be a big “no” for conservative investors. We only recommend using cash-covered PUTs and covered CALL options.
• Second, the stocks that we choose to write PUT options should be the ones that we would not mind holding for the long term. If a trade was to go against us and we were assigned the shares while the share price dropped significantly, we could just hold the stock until the price recovered close to our buying cost.
• Next, we should preferably use only dividend-paying and dividend-growing stocks for options. If we were forced to hold shares for the medium to long term, not only would we be paid for waiting, but the dividend growth stocks would have a much better chance of recovering quickly.
• Further, for any stock that you think that long-term upside may be too great to lose and your holding position is the bare minimum, you should refrain from using such stocks for call options.
• Last but not least, we should not chase very high premium rates to avoid risk, as they’re high for a reason. We should keep our expectations in check and aim to earn an average of 10% to 15% premium (annualized) on dividend stocks.

Options Income Strategy 101

Note: This section is for readers who do not have much prior exposure or experience with Options. Please see our blog post by clicking here.

Selection Strategy For Underlying Stocks

One of the most important aspects of writing or selling options is to select the right kind of stocks and to use the right kind of options strategy. What kind of stocks will be suitable will depend on the investor’s goals and risk profile. In this monthly series, we will present three lists of 10 stocks, each with different characteristics. Please note that some stocks may appear in multiple lists. We will scan the complete universe of stocks and apply some broad-based filtering criteria to make our list smaller.

1. The market cap of the company is near or higher than $10 billion (this can be lowered somewhat in a down market).
2. Daily volume for the underlying stock to be > 100,000.
3. Dividend yield preferably > 1.5%; however, we would make some exceptions for well-established dividend stocks (for example, stocks like Apple (AAPL), Microsoft (MSFT), and many others) at this initial stage.

By applying the above criteria, we get roughly 600 stocks.

Since our goal is to look for companies that we do NOT mind owning for at least in short to medium term, we will filter out the companies that have less than five years of dividend growth history. This filter leaves us roughly 300 companies that have a consistent record of paying growing dividends for at least five years, preferably longer.

Now, we will import financial data for each company in our list. We want to see the dividend safety of each company, at least on a relative basis. So, we import the following data elements:

1. Number of years of dividend growth history
2. Dividend growth during the last year, three years, and five years
3. Dividend Payout Ratio (preferably based on cash-flow basis rather than EPS)
4. Debt/Capital
5. Return on Capital – ROC
6. Sales Growth during the last five years
7. Credit Rating (from S&P)
8. EPS growth rating.

We will combine these factors and calculate a dividend safety score for each company. Sure, a high safety score would not guarantee absolute safety because business conditions can change over time, new competition can emerge, or the management can get distracted or make some bad decisions destroying shareholder value. Nonetheless, a high dividend safety score will at least provide a reasonable level of assurance that the company has the financial capability to continue making its dividend payments for the foreseeable future.

We also will import the data on price movements related to 1-week, 4-weeks, and 12-week price performance for the selected stocks to help in filtering the probable candidates for writing PUT options. We also obtain the relative strength data to shortlist stocks that have a recent price momentum.

We’re going to use our proprietary formulas (as detailed below) to calculate the optimal strike prices for CALL and PUT options. However, there are many other ways to determine the appropriate strike prices. The readers are encouraged to try several methods before determining what works best for them. There are many other ways to determine the appropriate strike prices. Your brokerage provider may provide more information on variables like delta, gamma, theta, etc., and how they can be relevant to options.

We also will calculate the following ratios and factors:

Distance-Ratio = (52-WK-HIGH – 52-WK-LOW)/((52-WK-HIGH + 52-WK-LOW)/2)

Distance-Ratio % = Distance-Ratio x 100

• Strike-Price Safe Distance

Strike-Price-Safe-Distance % = [(Distance-Ratio %) x STPR-factor (STRIKE-PRICE-factor)] / 10

Whereas STPRC-factor = 1.2 (can vary from 1.0 to 1.5)

• CALL Option Strike-price = Close-price + (Close-price x Strike-Price-Safe-Distance)

This price may need to be rounded to the lowest dollar or half-dollar amount depending upon what strike prices are prevailing for the underlying stock for the specific strike date.

• PUT Option Strike-price = Close-price – (Close-price x Strike-Price-Safe-Distance)

This price may need to be rounded up to the nearest dollar or half-dollar amount, depending upon what strike prices are prevailing for the underlying stock for the specific strike date.

Below, we present two lists of 10 stocks each, one for writing PUT options and the other one for writing CALL options. The second list is presented with two different options – the first one with stocks that you may want to own (or already own), whereas the second one is using the same stocks for the purpose of earning a high rate of income but possibly avoiding owning them. Please note that some stocks may appear in multiple lists as they may satisfy the criteria for more than one category.

10 Option Stocks Suitable For PUT Options

For PUT options, with the primary objective of generating income, we would want to see them expire worthless. So, we will analyze the 1-week, 4-week, and 12-week price performance as well as Relative Strength and try to see if it’s a rising trend or a downward trend. For writing (or selling) PUT Options, we want to select stocks that have a rising trend. These are the stocks that generally would have high relative strength or momentum. That will help ensure that, more than likely, the PUT option will expire worthless. In the reverse situation, if the option was assigned and we were put the shares, the rising trend will help that we are able to write the CALL option immediately with a good premium.

In our list, we’re careful not to put too many names from the same industry segment. We generally limit to two or three names from the same sector for the sake of avoiding too much concentration in one sector.

One important caveat for selling PUT options: Do not start a PUT option on a stock that you do not see yourself holding for an extended period of time. Also, please note that this list only highlights probable good candidates, but further due diligence is required.

Here are the top 10 large-cap stocks for PUT options:

(MPW), (MKTX), (FRC), (MS), (JBHT), (BHP), (SWKS), (CNQ), (CMCSA), (NTR).

Table 1:

Below, we present the current PUT Options trades and current premiums that we can expect for the above ten stocks. Please note that due to the current market environment, we have selected rather conservative strike prices and sacrificed a little bit of premium income. So, the average premium or annualized returns are slightly on the lower side.

Table 1A:

10 Option Stocks With Safe Dividends (PART-A)

In this category (part-A), we’re assuming that you already own these stocks (or you will be happy to own them at the right price). So, we’re aiming for an average of 2% dividend and roughly 10%-12% income by writing call options.

In this category, we will list ten large-cap stocks that are perceived to have very safe dividends. There’s nothing that we can claim to be absolutely safe in the investing world – the same can be said about dividends. But based on various financial metrics, we can shortlist companies that have low payout ratios, low debt, high credit ratings, positive top-line growth, and have been consistently growing their dividends. We present ten such companies below:

Our Top 10 Stocks with relatively safe dividends for (BUY-WRITE) CALL options:

(CTRA), (STLD), (EXPD), (JBHT), (TFII), (IMO), (MSFT), (NTR), (OC), (BMY).

Table 2:

Note: The “Dividend Rating” (the last column above) is based on recent past parameters like 5-year dividend growth, number of years of dividend growth, Payout Ratio based on cash flow, ROC, Sales growth, Debt/capital, and Relative Strength.

Below, we present the current CALL Option trades and current premiums that we can expect for the above ten stocks.

Table 2A:

10 Option Stocks With Safe Dividends (PART-B)

In this part, we are assuming that you do not own these stocks to start with, and your goal is NOT to own these stocks but simply to earn a high income (>= 15% annualized rate). Even then, there’s always a chance that we could end up owning these companies, so we want to make sure that their dividends are safe. Also, this option is better if you think that the market will fall from the current levels.

To achieve this, we will use the buy-write CALL option (for one contract, buy 100 shares and sell one call-option contract at the same time). Since the goal is simply to earn a high income, we will sell the call option with a strike price that is deep ITM (in-the-money), meaning the strike price is much below the current price. In normal circumstances, the odds will be very high that the shares will get called away, and we will earn a high premium. It’s also possible in some cases that the shares are not called away as the price may fall substantially. In such a case, our cost basis will be much lower (roughly 5% to 10% lower than the current price due to the premium already earned), and we can write another set of call-option.

Caution: However, there’s one caveat here, and it’s an important one. In case you write such call options on a large number of stocks (10 different stocks in our example below), and if the market was to take a deep dive (> 10% down) during the option period (which is always a possibility but more so in the current environment), the majority of our shares would NOT get called away, and you will end up owning most of these stocks, albeit at much-reduced cost basis (on average -7% to -10%). So, it’s important to know how much capital you’re willing to commit and if you can really afford to allocate it. Secondly, you always want to use this strategy with stocks that you do not mind owning and holding for an extended period of time.

This list of stocks is the same as in Part-A:

(CTRA), (STLD), (EXPD), (JBHT), (TFII), (IMO), (MSFT), (NTR), (OC), (BMY).

Table 3:

Conclusion

Please review the goals of each of the three distinct strategies carefully. We think these lists could be great selections for writing/selling PUT or CALL options. We have tried to put relatively safe stocks in all groups; however, the stocks listed in the second list (parts A and B) for call options (or buy-write call options) have been specifically filtered based on the safety of their dividends. However, nothing is absolutely safe in the investing world. Also, if generating income was your only objective, the second list (with the second option) is the safer bet.

We expect 60% to 80% of our options to expire worthless, earning us the upfront premium. But there will be times (just like the current market environment) when we’re assigned a stock. Usually, it should not be a problem, as we can turn around and write a covered call option. But there will be times, especially during high volatility periods, when the stock price may drop unexpectedly and significantly below our strike price. In such cases that are hard to predict, we will have to sell CALL options far out of money, earning us very little premium (or sometimes no premium at all) but still earning the dividends. This will reduce the overall premium yields by 2%-3% in the long term, but this can be easily offset by the capital gains we may earn from time to time. So, overall, it may be quite reasonable for us to expect 10% to 12% income on a consistent basis, as long as we play it wisely and conservatively.

In the current environment of great uncertainty, we need to be extra diligent in what stocks and strike prices we choose. There are many ways to determine the appropriate strike prices, but we have used our proprietary formulas to calculate the optimal strike prices. We suggest you perform your due diligence on each individual name if you decide to play the options.