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How Do You Sell Options To Generate Amazing Returns?

May 29, 2008
In this article we will look at how to effectively implement this strategy to increase your wealth. But before we do it's important to recognize that this strategy offers you the benefit of cash returns and easy access to your capital. Why are these things so important?

Cash returns:

Let's look at cash returns first. The best way is probably to use a comparison to another investment alternative such as property. Too many investments don't offer you good cash returns (only good capital returns), but your ability to generate cash is essential to achieving the freedom you need to pursue attractive wealth creation opportunities. In the UK at the moment the average rental property will generate approximately 5% return. Let's say you need $50,000 to live each year and you have managed to accumulate $100,000 in savings.

If you decide to buy a $200,000 property and you invest your $100,000 and borrow the balance at 5% you would generate a positive $5,000 net cash return every year (assuming no other property related costs such as management fees, repairs, etc). In essence you'd have to by 10 properties to generate the $50,000 annual cash you'd need to survive. That could take a long time and in the mean time you're spending your productive hours working for someone else to earn a paycheck to live off...and missing loads of opportunities. I love property as an investment and own numerous rental properties but it is not a great method of generating cash flow...well not without a great deal of work!

Selling options on the other hand can pay you a cash flow in the terms of a premium every month or two. It's a regular cash flow that you can use to help you quit your job and spend your time building your own wealth rather than your employers. Using effective options strategies that generate between 30% and 50% returns per year would earn you $30,000 to $50,000 per year off your $100,000 savings in a regular monthly income. This would give you incredible freedom and independence to spend your productive hours working for you not an employer. This is the importance of cash flow.

Access to capital:

The second key thing to remember is that options allow you quick access to your cash. Property in contrast takes many months and large costs to realize your cash investment. Your option investments require you to place initial margin with your broker to cover the risk of potential losses, but since your options expire every month or two you receive your initial margin cash back each time. Also it is really easy to buy or sell your options back at anytime at a very small cost (commission) to gain immediate access to your cash if you need it. This is often one of the main benefits cited by Wall Street to investing in stocks.

So now that you know two crucial reasons why options are vital to your wealth creation arsenal it is time to examine option selling strategies...

Option selling:

I like to use an example as a way of illustrating the strategy of selling options as a means to generate brilliant returns. I'll assume you are familiar with selling calls and puts and that you know your returns are limited to the option premium you receive and that your losses are theoretically unlimited. Though I will elaborate on what this really means as we work through the example.

On the 28th March 2008 gold was trading at $932 an ounce. The June 1 $700 put was bid $0.90 which means that each option is trading at $90 (i.e. 100*$0.90). Now at this stage it helps to actually have a view on the instrument you are trading. In the case of gold I have been extremely bullish for a long time due to a number of factors including the high U.S. inflation rate, collapsing U.S. dollar, poor current account, falling interest rates, huge government and private sector debt etc which all indicates that investors will move their money to a "safe" investment...gold! Now the point here is that I don't know when gold will rally nor do I know that it will rally really at all...what I'm confident on is that it won't fall very far. This means I can sell put options confident that fundamentals mean that the price of gold should not fall from current levels...and even if it does it's not going to fall to $700 an ounce by 1st June.

Each gold option is worth $93,320 (i.e. $932*100) so selling one option and earning $90 in two months might not sound like much but we need to look at it from a few different angles. A $90 return over two months on $93,320 is an annual 0.6% return which quite frankly is rubbish, but this is not the way to really look at this investment. The notional (face value) of the option really doesn't matter. Why? Well because that is not what you are paying for the option. You are not really buying $93,320 worth of gold (or even $70,000 worth at the strike price), but rather a way out-of-the-money put which requires you to only pay a small initial margin.

The initial margin on one gold $700 option is about $900 which means that over a two month period I would be able to generate a $90 return on a $900 investment. Viewed this way my return would be 60% per year (i.e. 10% every 2 months)! Now that's an amazing return...so does this mean I should rush out and sell 100 puts and generate a $9,000 cash flow over the next two months? Well not unless you were worth millions I wouldn't recommend it. Why? Because the unforeseen can happen. Selling 100 $700 put options means that for every dollar the price of gold falls below $700 you would lose $10,000 (i.e. 100 options * $100). So if the price fell to $650 you would lose $500,000. Ouch. So what do you do?

You strike a balance. You never expose yourself beyond what your can afford to lose in an individual trade and you manage your risks via stops. Taking the $100,000 cash worth example what would happen if you sold 5 options. Well you could earn $450 in two months (i.e.5*$90) equating to $2,700 per year in income. Your initial margin to the broker would be $4,500 (i.e. 5*$90) still giving you a 60% annual return. Your risk is now $500 per dollar below $700, which is a fully manageable exposure on your $100,000 capital given the extremely unlikely possibility of gold falling that far.

The second way of managing your exposure is through stops and the KISS method is always the best method. Easy to understand and easy to implement. The two best methods I know of are:

1. to stop out when your option doubles in value against you (or triples for the more adventurous). This method is simple and effective for the more risk adverse investor. I've found that it's not always the best when you are selling way out of the money options as you can be stopped out but still never really be at risk of your options being exercised, thus forcing you to take losses unnecessarily. But it is the safest route.

2. to stop out when the price of the underlying reaches your strike price. In our example your stop would be at $700. The problem with this method is that your losses would be much higher than the first method but obviously the likelihood of your stop being breached are much lower.

The strategy I usually use is to find many of these attractive deals and never expose myself too much to one trade (a lesson I've learned the hard way!), which will ensure you will sleep peacefully at night...just as I do! So if you take the above scenario how many trades should you place at any one time? Well you need to find a balance between putting your capital to work (i.e. your $100,00) which is used it as initial margin on trades and saving enough of it such that you can meet margin calls if positions go against you in the short term, so you are not forced to close positions or make margin calls. Again applying the KISS method is easiest and the simplest way is to put no more than 50% of your capital as margin at any one point in time. Any more than this could lead to unnecessary stress of margin calls if positions go wrong and means your positions are too large.

Taking our gold example and replicating it to other trades we could place $50,000 as initial margin which would generate a $30,000 annual return ($90*$50,000/$900*6) or a 30% annual return. I now enjoy a fantastic regular income on my cash capital through options investments and non-stressfully earn a comfortable 30% to 50% annual return on my cash capital.

The final word on gold...

Was I right about the price direction of gold? Yes and no. The price of gold (at the time of writing) has actually fallen to $882 (it has been as low as $850) so my expectation that gold would rally from $932 proved slightly wrong (or at least premature!), but was i really wrong? Well the price of my options have fallen over the past month and a half from the $0.90 I sold them to be worth virtually nothing. So even though the price of gold has actually fallen I've made money...wrong and still right! Options are truly an effective wealth tool.
About the Author
Emlyn Scott is the founder of Rich1Percent , investor and wealth creation author. He is a wealth creation and finance expert with 4 post graduate qualifications and has amassed a multi-million dollar investment portfolio.
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