So you want to trade options, huh? Welcome to this magical and dangerous world that most try to avoid at all stops.
The key to trading options successfully is having a clear income goal, defined expectations, and a rock-solid plan to avoid being greedy. Greed is the number one way to lose lots of money in the options market.
Where should you start? There are tons of complex strategies (read “The Options Playbook”) for trading options, but I wouldn’t recommend those off the bat.
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Instead, let’s focus on the basics: selling covered calls and selling cash-secured puts. Both techniques avoid using leverage; however, you can still find yourself underwater without the proper training.
The key to utilizing both of these strategies successfully is keeping your cost basis as low as possible. If you focus on your cost basis, you’ll have much better results than trying to make as much money as possible.
What is your cost basis? Your cost basis is the average amount of money you spend to acquire your stocks. If you bought 100 shares of AT&T (T) for $1,500, your cost basis is $15 per share.
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Your goal is always to keep your cost basis as low as possible. When you trade cash-secured puts, you won’t have any shares but will have the cash to purchase them. So, let’s start our journey with selling cash-secured puts.
Using technical analysis to sell cash-secured puts. Selling cash-secured puts can be a jarring experience if you don’t understand the charts.
When I first started selling cash-secured puts for Palantir (PLTR), I didn’t know anything about its price history. This allowed me to accumulate shares with a cost basis of $17 when the average price was $15.
The worst-case scenario is acquiring shares with a high-cost basis and waiting for the price to recover before trading options again. This is the position I was in for almost three months. But why did this happen?
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After putting myself in this position, I read “Mean Reversion Trading” to give me more insight into technical analysis when trading options.
This book gave me the basic parameters to set for studying stock charts. I use Yahoo Finance to plot the Bollinger bands and Relative Strength Index (RSI) to provide a good picture of where the stock falls according to its history.
According to my picture, PLTR is high on its trading path. This is not an ideal position to trade cash-secured puts. If you acquire shares, say at $18, chances are the price will fall to $15 over the next few weeks.
That would leave you with a cost basis of $18 when you attempt to sell covered calls. If someone exercises your calls at $15, you lose $3 per share—the worst possible outcome.
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The RSI also shows 64, which is a little on the high side. Typically, anything above 70 is high (overbought) and below 30 is low (oversold). With a score of 64, people may be looking to sell their shares and take profits.
When trading cash-secured puts, ensure you understand where your stock falls on its price history. The goal is to wait until it has a significant dip in price (say 5%) and then sell your puts.
You’ll understand the epp and flow more as you sell your puts. Don’t do what I did and try to “guess” what the price should be when selling. Set a maximum price (in this case, say $16) you will sell at, and wait for the best time to sell.
Selling covered calls. Once you have shares in hand, it’s time to sell covered calls to keep your passive income dreams alive.
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Covered calls are much easier to sell because you already know your cost basis, so the goal is to keep people from exercising your shares away.
This is where the greed and fear factor comes into options trading. When you look at the options chain for your stock, you’ll see that you make the most money when you find a strike price near the current stock price.
Currently, PLTR trades at $18.60. That means you’ll get the most money for selling covered calls at $19.00 and cash-secured puts at $18.50.
Should you sell your covered calls at a $19 strike price? That all depends on your cost basis. If you have a cost basis of $17, then you stand to make $2 per share plus the premiums.
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If your cost basis is $19.50, you’ll want to trade at a $20 strike price. That will significantly lower your premiums but keep you from losing money if someone exercises your calls.
The give and take of options trading. As you can see, options trading is all about give or take. Trading at strike prices near the current stock price gives you the best income; however, it can also put you in a hurt locker later.
You’ll need to balance your lust for money with what is right for your portfolio. Essentially, you are trying to keep the lowest cost basis possible while generating the highest returns.
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Trading options for passive income. I find it best to set a realistic passive income goal, so you won’t expect too much from each trade.
Let’s say you have $10,000 in your options account. I think generating $500 per month is an admirable goal to set. You can trade five options contracts and generate that much income without much fanfare.
Is making $500/month against $10,000 a good return? I wrote about your financial mindset in “Treasury Bonds vs. Options Trading.”
If you had $10,000 invested in Treasury Bills at 5%, that would generate $500 per year. Again, that’s $500 per year.
With options trading, you can generate that same $500 per month for $6,000 per year. I think a 60% annualized return is pretty freaking amazing.
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Conclusion. Again, it’s all about your financial mindset. If you go into selling covered calls and cash-secured puts to double your money every month, you’ll have a tough time.
You can easily double your money with risky trades, but you can just as soon lose all of your cash. I started my account at $20,000 and quickly got underwater with my cost basis.
I read “Mean Reversion Trading” and stopped trading at inopportune times. I know I am sitting at $23,000 after withdrawing over $2,000 over the last few months.
I am getting precisely what I want from trading options—passive income. The key is waiting for the best time to trade puts and calls. If your stock has a terrible day, sell a put for the lowest strike price.
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If your stock has a fantastic day, sell a call for the highest possible strike price. This ensures that your options don’t get exercised, and you continue to make money every month.
Once you feel comfortable selling covered calls and cash-secured puts, we can move into more complex strategies.
That way, instead of waiting all month for the best times, you can win at even more price points. I like to trade long strangles while I wait for my covered calls and cash-secured puts to expire.
With the right mindset, temperament, and goals, trading options can be an excellent addition to your passive income portfolio. Take your time, keep your cost basis low, and learn the epp and flow of your stock price. Your patience will pay off. Good Luck!
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Disclosure: I am not a financial advisor or money manager, and any knowledge is given as guidance and not direct actionable investment advice. I am an Amazon Affiliate. Please research any investment vehicles that are being considered. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. All Right Reserved Military Family Investing
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