Manufacturing Income and Mathematically Reducing Risk
By: Rich Greer and Robert Valentine
In college, I observed the business of rental property ownership. The landlord/tenant relationship provides suitable temporary housing for the student and income for the owner. For the landlord, this asset is used to generate consistent cash flow while accumulating appreciation. The renter provides the income flow, but will never have ownership stake in the property.
Now, imagine the opposite scenario in the stock market. You can create certain cash flow and potentially accumulate appreciation from an investment you do not own.
We’re talking about selling put options (not buying options). This strategy allows an investor to generate consistent spendable income; often up to ten fold the current average market rate.
Reduced risk with income? How does it work?
An investor sells the put option to a buyer for an agreed upon amount known as a ‘premium’. The premium amount is non-refundable and the seller always gets to keep this amount; even if the option is never exercised. In return, the seller is left with an obligation to buy an agreed upon number of shares at a set price. That price is known as the ‘strike price’. The option also must be executed within a certain period of time. The end of that time period is known as the ‘expiration date’.
There are two possible outcomes:
- The strike price is not met by the expiration date. The stock option expires worthless to the buyer and the seller keeps the premium amount.
- The strike price is met by the expiration date. The seller of the put option is obliged to buy the stock at the strike price, with a lower cost basis then the market.
The first scenario is a win-win situation for the seller. The seller profits from the premium amount but is back at square one in regards to acquiring the stock. Not to worry since you can sell put options multiple times a year on the same stock. This can result in consistent income from your investment coming in the form of premiums.
The second scenario is also a win-win situation for seller. This means you fulfill your obligation to acquire the stock at a locked-in price (strike price) that is often lower than the price the seller could have acquired the stock at the time of the option contract (strike price minus premium received), without all your capital at work.
What if the stock’s value falls below the strike price by the expiration date? At this point you are obliged to acquire the stock at the strike price. However, if the strike price was set less than the valuation at the date the option contract was entered, you’re still acquiring the stock at a discounted amount compared to the contract date. True, there is opportunity loss. Had you never entered into the option agreement you could have acquired the stock now at an even lower price. However, you still acquired the stock for less than the amount available at the option contract, for a stock you expect will appreciate over time- and you created income.
By using this strategy, you can reduce the risks involved with market volatility levels while providing protection from large negative swings in a stock; all while you collect consistent monthly returns on your investment.