I’ve been talking about how options can enhance not only dividend payments but also help investors buy stocks “on sale” and even make a little extra money along the way. So, I thought it was time to begin explaining how all this works.
Before we get started, let me reassure you of something. If you’ve always thought options sounded complicated, you’re not alone. Most people do. My goal is to make them a little less mysterious.
I also want to make something very clear.
My goal is not to turn anyone into an options trader.
Instead, I want to show how a few basic option strategies can benefit those of us who are retired and looking to generate passive income, mainly through dividend stocks and ETFs.
So… let’s get started.
A Call option is simply a contract that gives someone the right—but not the obligation—to buy a stock at a certain price before a certain date.
That sounds a little intimidating, but it’s actually very similar to buying an option on a house.
Suppose there’s a house you really want, but you’re waiting for your current home to sell. The seller agrees to hold the property for you for 60 days at a price of $700,000. In exchange, you pay the seller a non-refundable fee of $5,000.
Why would you do that?
Because if housing prices continue to climb and similar homes are selling for $725,000 two months later, you still have the right to buy the house for the agreed-upon $700,000. Even after paying the $5,000 fee, you’re still ahead.
That’s basically the idea behind a Call option.
The fee you pay for that option is called the premium.
Now let’s apply the same idea to stocks.
Suppose you’ve been watching XYZ stock. It’s trading at $70, and you think it has a good chance of moving higher over the next month. Instead of immediately buying the stock, you decide to purchase a Call option with a $70 strike price that expires in 30 days.
The strike price is simply the price at which you have the right to buy the stock before the option expires.
The option costs 50 cents per share.
Options are sold in contracts of 100 shares, so one contract costs:
$.50 × 100 = $50
If you buy two contracts, you’ll spend $100 and control 200 shares of stock.
(Don’t let all this terminology scare you. The mechanics of buying and selling options are handled by your brokerage. You don’t have to find someone to buy from or sell to. You simply choose the stock or ETF, the option you want, and your brokerage takes care of the rest. As we move through these lessons, I’ll show you the decisions you make—not the behind-the-scenes mechanics your broker handles for you.)
Let’s look at two different outcomes.
Scenario One
Things don’t go as planned.
Instead of going up, XYZ falls from $70 to $65.
You think to yourself…
“Well, that didn’t work out—but I’m glad I didn’t buy the stock.”
Your total loss is the $100 you spent on the two option contracts.
Had you bought 200 shares of stock instead, you’d be down $1,000.
($5 loss × 200 shares.)
I call that limited-risk speculation.
Scenario Two
This time your prediction is correct.
XYZ rises from $70 to $75 before the option expires.
Because your option gives you the right to buy the stock for $70, you’ve gained $5 per share.
On 200 shares that’s a $1,000 gain.
Subtract the $100 you paid for the option, and you’re ahead by $900.
You could purchase the stock and keep it as a long-term investment.
Or now that you own the stock, you could simply sell it and take your profit.
Either way, the option gave you the opportunity to control much more stock with a much smaller investment.
One interesting thing about options is that they can sometimes increase in value much faster than the stock itself. That’s one reason many professional traders simply trade the option rather than the stock. This is called leverage.
We’re not going down that road here, but I wanted you to understand why options receive so much attention.
Now let’s get back to why we’re talking about all of this in the first place.
Remember when you paid 50 cents for your Call option?
Where did that money go?
It went to the seller of the option.
That’s important because ETFs such as QQQI own millions of dollars’ worth of stock. By selling Call options on many of those holdings, they collect option premiums over and over again.
Those premiums become an additional source of income, which helps support the attractive dividends they pay shareholders.
Now you’re probably wondering…
“What happens if someone decides to buy the stock from the ETF?”
Great question!
If the buyer exercises the option, the ETF sells those shares. Later, it can purchase new shares to replace them as part of its normal portfolio management.
Funds don’t all manage their options the same way.
QQQI generally sells options with strike prices that are further above the current stock price. That gives the stocks more room to rise before they’re called away.
Funds like QYLD, on the other hand, tend to sell options closer to the current stock price. That usually produces more option income, but it also means their stocks are called away more often, so they don’t benefit from as much stock appreciation.
Personally, I’m okay with that tradeoff because I like the income. Everyone has to decide what fits their own goals.
One last idea before we call it a day.
Suppose you already own 200 shares of XYZ stock at $70.
You can also become the seller of a Call option.
Let’s say you sell a 30-day Call option with a $75 strike price for 50 cents per share.
Since you own 200 shares, you collect $100 immediately. This is called a Covered Call.
That money goes right into your brokerage account.
Covered Calls are generally considered one of the more conservative option strategies because you already own the stock.
The only real downside is that if the stock rises above $75, someone may buy your shares at that price.
But think about what happened.
You collected $100 for selling the option.
Your stock increased $5 per share.
On 200 shares, that’s another $1,000 (200 x $5) in appreciation. So, your total gain is $1,100.
Not a bad outcome at all.
The only question is whether you wanted to keep the stock for the long haul or whether you were happy taking the profit.
That’s simply a personal investing decision.
Phew!!
I’m tired. 😄
If you’re still with me, congratulations! You’ve just completed your first lesson on Call options.
Next time we’ll talk about Put options and how they may help you buy stocks or ETFs at prices you’d actually like to pay.
If you enjoyed this article, please click the Like button below and, if you haven’t already, subscribe to the blog also at the bottom of the page. It’s completely free, and you’ll receive an email whenever a new article is published.
I’d also love to hear your questions or comments. You can leave them at the bottom of this page or email me at ponzot2004@yahoo.com.
Until next time,
Tony
Leave a Reply