This article is part of the series

Options Plays for Dividend Fans

Options Trading TradeKing


Nicole Wachs reviews a few popular options plays to a trader seeking income 

Many investors and traders nowadays can't get enough of dividend-paying stocks and other fairly steady sources of income. If you count yourself among that group, though, are you fully aware of the various options strategies that address this outlook - plus help you hedge your positions against downside risk? Consider this forum question from Coog84

Hello,

Just to give a brief background, I am a DRIP investor and love buying strong companies who pay out steady dividends (i.e. KO, PG, etc). Each month I purchase roughly $6k worth of a dividend paying stock.

Recently I have been thinking about writing naked put options to make some additional passive income. My question is, when I'm ready to purchase a stock like KO, would it make sense to write a put option right below the market price to purchase it? Also, would there be any reason why I wouldn't pick the expiration date furthest out rather then one expiring in one month in order to make a higher premium?

Thanks,
Coog  
  
Coog, 
As I’m sure you are aware, purchasing $6k of stock per month represents a pretty good size portfolio. Here are a few thoughts that should be considered for any size account.

I’d like tobe certain that you are aware that selling naked puts should not be considered passive income. Those puts may turn intoan obligation to buy additional shares at the strike price - exposing you tosubstantial potential losses if you're not prepared. Naked puts require activemanagement, so I wouldn’t classify this as a passive strategy. 

For those who are unfamiliar: To reduce this risk to something more manageable, you should consider setting aside sufficient cash to buy the underlying should you get "put" the shares at expiration. Fittingly, this is called a  cash-secured put. Many bulls like cash-secured puts for another reason: if they get assigned, this position can prove a handy way to subsidize your purchase of the underlying shares. (The subsidy, of course, would be the premium you collected upon selling the put in the first place.) So selling cash-secured puts just below the stock’s current market price is one strategy to consider. This is often done with options expiring in the first or second month. 

Though you are correct that selling a farther-term put will give you more premium, most traders consider doing this on a monthly basis if market conditions permit. One reason has to do with how time decay works. If you compare the premium for a six-month put and a one-month put, the one-month put would provide more premium if it was sold monthly for six months. The downside is this approach would incur more commission costs when selling the options each month. The upside is you would have more flexibility to adjust the strike price each month. (If you are really into the mathematical explanation, check out Brian Overby’s post on time value and the square root of time.) 

Obviously the idea of owning stock appeals to you, Coog, but instead of using options to buy more stock (or provide income when they expire worthless), have you considered using options as they were intended to be used: To hedge your portfolio? 

You could write out of the money covered calls, limiting your upside profits but providing regular income, which you obviously like. You could buy long puts – instead of selling them – for protection and pay for them by writing covered calls. This play is referred to as the collar. This play limits both your upside potential and downside risk, but it can be handy. I'd strongly encourage you to check out TradeKing's Options Playbook for definitions of each of these plays, including their potential risks and rewards.  

If you are, and want to remain, strongly bullish, then you will probably not want to hedge. However, markets do not always rise, and you may prefer to protect some of your assets in the meantime. 

Just a thought and I wish you good trading. 
    
Regards, 
Nicole Wachs 
Director of Education, TradeKing 

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options available at http://www.tradeking.com/ODD
  
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