Updated: Feb 22, 2020
Despite whatever strategy you want move forward with, you have to have reasons why you're doing it. And your answer shouldn't be because everybody tells you to use it. Over the past years I've tested several strategies which most believed were able to produce market-crushing returns. I gave every strategy a fair crack of the whip, but there wasn't one that provided me and parents with such a beautiful sought-after monthly cash flow that relatively simple option selling strategies were able to deliver instead.
First Things First: A Firm Foundation
Along with conservative buy and hold investing, where I focus like a laser on logistic real estate, residential construction, infrastructure and utilities, covered call writing and cash-secured put selling currently represent 59% of our investment strategy. I'm not here to tell you that option selling should be the only part of your portfolio, definitely not.
You should have a well-balanced asset allocation that you feel comfortable with. And in my eyes, everything has to start with conservative stocks to lay out a firm foundation to withstand multiple shocks on the stock market. You can then tweak it to your own personal risk tolerance by selling covered calls on the normal index (read my article about this topic here) and exploring the possibilities of short-term option selling.
Why is that? I've had the very good fortune of speaking with several retail investors and each of them had a different understanding about how to become financially independent. But they had one thing in common: a serious misconception about risk. Chasing highly risky investments won't produce consistently positive returns for you and your family. Instead, the most conservative stocks are often seen as safe havens courtesy of their predictable cash flows and steadily growing dividend streams that you - the long-term shareholder - receive. During steep market downturns, they tend to fall less than the more aggressive companies that generate fickle cash flows. So, it's winning by not losing...
Once you've constructed a well-balanced, diversified portfolio filled with high-quality stocks, you can then switch over other investment strategies such as short-term option selling.
What Is Option Selling About?
In essence, by selling covered calls or cash-secured puts we are paid a premium for undertaking a contract obligation. We only count the time value component of that premium as profit. Basically, in return for being capped on the upside, the premium is a cushion that will help us cope with potential price declines since it lowers our cost basis and breakeven level.
Whereas dividends are linked to corporate activities and subtracted from the share price on the ex-dividend date, option premiums are dictated by the market and won't affect the share price of the security that we sold an option on. In addition to this positive note, option premiums are not subject to a similar dividend tax (currently 30% here for Belgian stocks and a total 49.5% for foreign dividend payments), making them even more attractive.
Skill Set Required For Option Selling
When investors hear about the returns that covered-call writing can produce (my goal is 3% each month using a combination covered option selling and margin), they get super excited, thinking it's a free lunch. Although one-month returns of more than 2% are no exceptions, we need to master all the three components that will set us apart from the average investor in order to make the most money possible. Those three factors are stock price selection, strike price selection and position management when entering a trade. If we stick to these guiding principles, we can further enhance our chances of trading success to the highest level. When it comes to stock price selection, we always look for reasonably priced stocks that institutional investors pay attention to and stocks that are expected to outperform based on chart technicals. We always avoid stocks that are about to report earnings as those events create uncertainty among investors leading to elevated volatility and a vague outcome.
1. Stock Selection
Finding the most appropriate stocks to use in a covered-call writing or cash-secured put selling portfolio is one of the most critical things we have to get over. 99% of all retail investors doesn't think about what stock they're using, they just want to generate the highest possible returns they can find in the options chain. So, we have to screen for the best stocks eligible for our system and the no. 1 rule in the framework of my conservative strategy is to never ever sell options on a stock that is about to report earnings. The reason investors blindly sell options on those companies is because of increasing implied volatility in anticipation of the earnings release. My watchlist/portfolio of elite stocks eligible for option selling is part of our premium membership. The best 25 stocks based on sound fundamental and technical analysis as well as common sense principles like short selling, beta and industry diversification.
2. Strike Price Selection
It's quite impressive how few option sellers use different strike prices. When it comes to covered-call writing, in-the-money calls offer downside risk protection of your time value profit. The deeper in-the-money the strike is, the more protection we have but the lower the time value component of the premium will be. There is a tradeoff…more protection for less profit and vice-versa. When selling puts, in most cases we'll go with the out-of-the-money puts to possibly buy the stock at a lower price than current market value. Just like with covered-call writing, our maximum profit is limited to the strike price. More information on this topic can be found here.
3. Position Management
I've written and continue to produce several articles containing information on how to manage your trades after entering them. Don't be the type of investor who just sells an option, claps your hands and pray. That's not what we're all about! We have to be able to evaluate how the trades are doing and if something turns out much better/worse than we anticipated we have to take action to throw the odds in our favor and firmly keep the trades under control. More information on this topic can be found here for calls; here for puts.