As a dividend growth investor, I invest in high-quality stocks trading at reasonable valuations. My DivGro portfolio delivers a reliable and growing dividend income stream. By reinvesting dividends, I’m supercharging the growth that comes from regular dividend increases. Additionally, I’m adding new capital to my portfolio, allowing me to buy more stocks and further increase my dividend income.
One way to generate extra income for deployment in my portfolio is to sell options. While not without risks, selling options can be used as a way to generate income on a consistent basis.
Basics of Options
Options are derivative financial instruments whose value is linked to an underlying asset. In the case of stock options, the underlying asset is a stock.
A stock option is the right to buy or sell a specific stock at a certain price before a particular date.
A call option gives the option buyer the right to buy 100 shares of the underlying stock at the option’s strike price before the expiration date. To secure that right, the option buyer pays a premium to the option seller, who assumes the obligation to sell 100 shares of the underlying stock at the option’s strike price before the expiration date.
A put option gives the option buyer the right to sell 100 shares of the underlying stock at the option’s strike price before the expiration date. To secure that right, the option buyer pays a premium to the option seller, who assumes the obligation to buy 100 shares of the underlying stock at the option’s strike price before the expiration date.
The option buyer is also called the option holder.
To generate extra income for DivGro, I take on the role of an option seller. In doing so, I’m assuming the obligation to either buy or sell the underlying stock if the holder decides to exercise the option. In return for my obligation, I receive a premium upfront from the buyer.
Here is how I earn income from selling options::
- Covered Calls: I can sell call options on stocks I own. For example, since I have 100 shares of Visa (V) in my DivGro portfolio, I can sell a call option on those shares and collect the premium from the buyer. But I must be willing to sell my shares at the strike price if the buyer decides to exercise the option or if it gets assigned at expiration.
- Secured Puts: I can sell put options on stocks I want to own. For example, I can sell a put option on V with cash set aside to buy 100 shares if the option is exercised. I’ll collect the premium from the buyer, but I must buy the shares at the strike price if the option is exercised or assigned at expiration.
Benefits of Selling Options
Extra Income: The main benefit of selling options is the potential to generate extra income. Collecting premiums allows me to generate a consistent cash flow, especially in sideways markets.
Flexibility and Control: As the option seller, I can choose the strike price and expiration date based on my risk tolerance and market outlook. Moreover, I can close my position early and take profits or cut potential losses.
Probability of Success: As the option seller, I can increase my chances of success by selling options with strike prices that are less likely to be reached before expiration.
Risks of Selling Options
Market Risk: As the option seller, I’m exposed to market fluctuations and potential losses if the underlying stock price moves against my position.
Early Assignment Risk: When selling options, there is a possibility of early assignment. Covered calls on dividend-paying stocks have a higher risk of being assigned near their ex-dividend dates.
Unlimited Liability: I don’t sell uncovered (or naked) call options because there is no limit on how high the underlying stock’s price may rise.
When selling options, it is crucial to manage risk and limit potential losses. Ways to manage risk include proper position sizing, diversification, and setting stop-loss orders.
I started trading options in June 2016 with a covered call trade on Ford (F). In 86 months of options trading, I’ve collected over $100,000 in options income at an average of about $1,163 per month. I’ve reinvested all option income in my DivGro portfolio, buying dividend growth stocks to grow DivGro’s dividend income stream.
In this section, I want to share some example trades and relate them to the underlying stocks in my DivGro portfolio.
I own a small position of 10 shares of SYK, acquired in August 2019 at a cost basis of $209.80 per share. My position has a yield on cost of 1.43%.
I wouldn't mind increasing my SYK position by 100 shares. That's why I'm willing to sell one put option on SYK and wait for expiration or assignment:
|Expired||#632||2021-03-16||1||SYK 18Jun21 200 P||220.00|
|Expired||#688||2021-06-16||1||SYK 17Sep21 230 P||300.00|
|Expired||#716||2021-09-17||1||SYK 17Dec21 240 P||330.00|
|Expired||#780||2022-08-04||1||SYK 16Dec22 180 P||420.00|
|Expired||#848||2023-02-15||1||SYK 16Jun23 200 P||125.00|
|Expired||#906||2023-06-26||1||SYK 15Sep23 240 P||100.00|
In three years, I've collected dividends totaling $103.70 from my investment in SYK. At the current dividend rate, my 10 shares of SYK will deliver dividend income of $30 annually. In contrast, selling put options on SYK generated income of $1,495 in just over two years.
I own 100 shares of V, acquired in three lots (September 2018, April 2021, and November 2021) at an average cost basis of $204.32 per share. My position has a yield on cost of 0.88%.
V is a high-quality dividend growth stock with an A+ Dividend Quality Grade. The stock yields only 0.78% but has a 5-year dividend growth rate of 17.2%.
Since V is a low-yielding stock, I want to generate extra income by selling a covered call option on my shares:
|Expired||#757||2022-06-28||1||V 19Aug22 230 C||121.00|
|Expired||#791||2022-09-15||1||V 16Dec22 225 C||265.00|
|Expired||#820||2022-12-19||1||V 17Mar23 235 C||214.00|
|Expired||#861||2023-03-23||1||V 16Jun23 255 C||113.00|
|Expired||#907||2023-06-26||1||V 15Sep23 255 C||79.00|
In the time I've owned V, I've collected dividends totaling $432.13. At the current dividend rate, my 100 shares of V will deliver dividend income of $180 annually. In contrast, selling call options on my V position generated income of $792 in about 15 months.
Assigned Options, and Closing and Rolling Forward Options
In future articles, I'll share some example trades of options that got assigned, and options I closed early or rolled forward before the expiration date.
A majority of my option trades expire rather than get assigned.
I’ve been selling options since June 2016, collecting more than $100,000 in the process. I’m reinvesting all option income and buying dividend growth stocks to grow DivGro’s dividend income stream.
Selling options can be lucrative, but it requires caution, patience, and discipline. As with any investment strategy, it is important to understand the risks involved and employ proper risk management techniques.