The First Income Trade Every Beginner Should Make By Keith Kaplan, CEO, TradeSmith Whenever I talk about trading options, folks are quick to tell me it’s just too risky… That it’s just too easy to lose money with them. That just proves to me how misunderstood the options market is. Options are a de-risking tool. They help you buy stocks at lower prices and sell them for higher prices. Is there a learning curve? Sure… just like with anything worth doing. But once you understand the benefits of options trading, you quickly realize there’s a bigger risk in not trading options. Not to mention, by avoiding them, investors are missing out on one of the best income opportunities available today… You see, one of the biggest investing secrets is that you can create “income on demand” simply by selling options contracts. This strategy can deliver streams of income over and over again on a stock you own. Not only that, but this is the single safest options strategy there is. In many ways, it’s even safer than simply buying and holding stocks. Once again, there is that learning curve. But today, I’m going to help you climb it by showing you exactly how to use this simple, safe options income strategy… Options Have Never Been This Easy The fact is that options trading is easier and less costly than ever before. The numbers prove this. Globally, the number of options traded worldwide in 2023 was 108.2 billion, up 98% from the previous year. It’s easy to see why. With brokerages going digital and costs to trade essentially vanishing, anyone with a smartphone can now get in on the options market in a way that just wasn’t possible even 20 years ago. So clearly, a lot of savvy investors believe options are a great way to make extra money in the market. And as I see it, they’re right. Because once you step back and look at the whole picture, the biggest risk is the thousands or even millions of dollars in lost opportunity you face by NOT being in the game. So, let’s talk about actually trading options. And we’ll start by clearly defining how they work. Options are contracts that give the contract’s buyer the right – but not the obligation – to buy or sell a specified number of shares of a stock at a specified price (called the strike price), before an expiration date. A call option gives the buyer the right to buy that underlying stock. A put option gives the buyer the right to sell that underlying stock. With both calls and puts, you can take either end of the trade – meaning you can buy the option… but you can also sell (short) the option. Whether you are selling a call or a put option, the goal is the same: You want the value of the option contract – known as premium – to fall to zero. And this happens when the option contract expires with a strike price that’s “out of the money.” That’s when a call option contract strike is above the current price of the underlying stock, or a put option strike is below the current price of the stock. The Fine Art of the “Covered Call” Those are the basics. But let’s now focus on the income strategy of selling covered calls. As I just described, each call option contract gives the buyer the right, but not the obligation, to buy 100 shares of the underlying stock at the strike price by a certain date. Since you’re selling the call, the buyer pays you for that right – a payment known as the “premium.” If the stock stays below the strike price – or if the buyer does not “exercise” the option to buy the stock at the stirke price, which they would only do if it’s favorable to them – the option expires worthless and you, the seller, keep 100% of the premium. But what if the opposite happens? What if the price of the stock climbs above your strike price and the buyer exercises his right to buy the stock? The worst thing that can happen here is that you sell your shares – 100 shares per contract. Here’s an example. Suppose you want to trade a covered call option on Netflix (NFLX) to earn some income and reduce your cost basis. So, hypothetically speaking, let’s say you could buy 100 shares of NFLX at $100 and then sell the $110 covered call option expiring next Friday, July 12, for $1.00 in premium. (To be clear, this is a purely hypothetical example using simple numbers to make it easier to understand.) When you do this, $100 in premium ($1.00 x 100 shares) hits your account. If NFLX trades up to $110 by next Friday, the seller will have the right to exercise his call option contract and buy your NFLX shares at $100. And since you received $100 in premium, your cost basis on your NFLX position is effectively $99 per share. Your best-case outcome is when the contract expires worthless. You pocket the premium (ka-ching!) and you keep all the shares of your stock. The “worst-case scenario” is that the buyer executes the option and buys – or “calls away” – your Netflix shares for $110. In this case, you would profit $11 per share on your NFLX position, for a total profit of $1,100. The only risk is limited to some potential opportunity loss. Since you already own shares (100 shares per option contract) you may miss out on some gains as the stock moves above your strike price. But you’ll still pocket the premium and bank a capital gain by selling the stock for more than you paid for it. That is why it’s always a good idea to sell your covered calls at a price higher than what you initially paid for your shares. The worst-case scenario here is that you collected premium (which you get to keep no matter how the stock’s price moves) for selling the option contract… AND you sell your shares at a profit. In other words, getting paid to profit: the best “worst-case scenario” I’ve ever heard of. Even better, you can keep doing this over and over again by selling covered calls against the stocks you own for as long as you like – provided the contract is never exercised. If you’re new to options, I can’t emphasize enough that selling covered calls is the safest way to dip your toe in the water. But you should be certain that you have 100 shares of stock for each contract you sell. Selling a contract without owning shares is called selling a “naked call” and that can be incredibly risky. If you want to step into the options market, check your portfolio for any large-cap stock you own 100 shares of, and look up the options chain for some juicy premium you can earn. And if you’re a TradeSmith subscriber, make sure to head on over to the Covered Call Builder and use our best-in-class algorithms to highlight the highest-odds opportunities. All the best, Keith Kaplan
CEO, TradeSmith
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