Options can be a weird concept for people to understand. I know it took me a bit of time to be comfortable with how they worked and learning the “lingo” which goes with them.
So, when I was trying to explain my idea for a strategy to my wife one night, I had to think about how to put it into terms she would easily grasp since she’s unfamiliar with options.
That’s when it dawned on me…real estate. We both recently spent some time learning about real estate investing, so I felt I could make the connection that way.
But first, we need to rework what our definition of an “asset” is.
If It Doesn’t Have a Tail It’s Not a Monkey
Yup, that’s a VeggieTales reference…my mind has totally gone to the kids!
Traditionally, an asset was defined as, “something you owned”. A car, your house (very common) or a coin collection.
But let’s tweak this definition just a bit.
What if our definition was this:
An asset is something you own AND it generates revenue.
Huh, how do you look at your coin collection now? Or even your house. Does the house you live in meet this definition? I’d argue if you’re living in it, probably not.
Stocks are an asset because you own them AND they pay you, whether with dividends (an annual or quarterly payment) or through trading options around them.
Rental property is an asset as well. You own it AND it pays you. Remember if it doesn’t pay you, it’s not an asset.
If it doesn’t have a tail, it’s not a monkey…
Trading options can be like owning a rental house.
As I take a swing at this, think of it this way. The “”rental house” will be equal to the stock I’m trading around. In this case I’ve worked around Cliffs Natural Resources (CLF), so Cliffs is my rental house.
Before you own a rental house you first must buy it. You’re saying, “Tell me something I don’t know Mr. Naked Trader”. Yes, yes, yes…settle down.
With options, instead of buying the house outright I actually sell someone else the option to sell me the house at a certain price before a certain date. This is the basic idea of a put option.
It’s important to note, I already want this house. I already like everything about the house, I just want to get paid for giving someone the option to sell it to me.
I mention this because if you’re getting paid to buy a house you don’t want in the first place, how are you going to feel if you’re forced to buy it? Yeah, not good.
Getting Paid to Buy the House
My goal is to buy the house at a price I don’t think the house will fall to in the time frame of the option. Okay, let’s put some numbers to this. With Cliffs I sold puts around a strike price, the price the stock must reach to be executable, of $19 – $20 with about a week before the options expired.
So, what I was telling the market is, “I don’t think Cliffs will fall to $19 a share but I’ll sell you the option to sell them to me at that price”. This worked for a few trades, as you can see in my income reports, however I eventually “bought the house”.
Renting Your “House” Out
In April, I was forced to buy Cliffs at $20/share. Awesome, no worries. So, now that I own the house it became time to rent it out. This is when I began to sell call options, or the option for someone to buy Cliffs from me at a certain price during a certain time frame.
Here’s where I made my first mistake. I should have bought a “protective put” when I was forced to buy this particular stock because there were some underlying issues which made it unstable.
In the options trading world, this technique (a protective put + covered call) is called a collar.
This would allow me to sell them back at the price I was forced to buy them at. Unfortunately, it took me a bit of time to realize this and it cost me.
The point of this protective put is to protect me from a significant drop in Cliffs share price, which is exactly what happened. Since I picked up Cliffs it has been in a free fall. I was hoping to be able to rent out Cliffs faster than the share price fell, however this hasn’t been the case. Thus the need for the protective put.
Now that I have Cliffs, I’ll just keep selling calls (aka “renting it out”) until the stock gets called away from me (I’m forced to sell it). Before then I hope to make enough “rent” to break even on the cost of the put, which was $950. I’ve got a ways to go but I’ll get there!
Just Keep “Renting”
So, like a house on the market, the value of the house can drop, drop, drop, but you can still rent it out to people. As long as the house doesn’t burn down before you can sell it you should be good.
So, if you bought a house for $150k, then the market value dropped to $145k over the next year, most people would think they’re screwed. However, if during that time you rented your house out for $15k you could sell it at its current value of $145k and then with the $15k in rental income you’d come out at $160k…$10k in profit!
Of course the numbers aren’t that big with Cliffs right now, but I hope this gives you the gist of the concept I’m working around. As with all things, I’ll continue to refine it and see how well it works. If it doesn’t work out now I figure, well, I’ll just trash it and go back to the drawing board!
Let’s Do This!
So here’s a recap of the main points of the trading concept I’m working with:
- Pick a stock (see my post on Popular, Volatile, Established and Cheap for my process)
- Sell puts below what you think the value will drop to
- When/if you get “put” the stock, buy a protective put at/above the price you bought the stock
- Sell calls until the stocks is called away or it is time for your “put” to expire
- Rinse and repeat!
Thanks for taking the time to read up on my crazy concept for trading options for a monthly income.
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