The main goal of many investors is income generation, be it for a steady flow of cash that can be reinvested, or for a flow of cash that can be used to pay for one’s living. Dividend growth investing has turned into a very popular strategy for income oriented investors, but there are other possibilities as well, utilizing cash secured put options.

What Are Options, And How Do They Work?

A stock option is a standardized contract that allows the stock option buyer to purchase (or sell) 100 shares of a specified company at a specified price (strike price). The buyer of the option is not obligated to exercise the option. The seller of the option, who is also called the writer of the option, is forced to hold up his part of the agreement if the buyer of the option wants to exercise the contract. In turn for providing the stock option buyer with a lot of flexibility, the seller of the option is rewarded through an upfront cash payment, the so called option premium. Option contracts always have a specified life span during which the option can be exercised. There are two main types of options:

• Call options allow the buyer of the option contract to purchase 100 shares of the specified company.
• Put options allow the buyer of the option contract to sell 100 shares of the specified company.

How Writing Put Options Can Be Beneficial For Income Focused Investors

Now that we know that the writer/seller of the option contract receives the so called option premium in turn for giving flexibility to the buyer of the option, we can guess that selling options can be used to generate some form of cash income for the option seller. The size of the option premium depends on several factors, including the strike price, the volatility of the underlying stock, and the life span of the option.

If the buyer of the option decides to exercise it, the seller of the option contract is forced to acquire 100 shares (per contract) from the buyer of the option. This means that the seller of the option should hold enough cash in his portfolio to be able to acquire the shares he has agreed to acquire at the specified price. In that case the option would be called a cash-secured put option.

Since most investors are only interested in a limited number of stocks, put options should only be sold when the seller of the put option contract is, in general, interested in owning the underlying security. Selling put options can, therefore, be a good strategy if one would like to own a certain stock, but not at the current price.

If, for example, an investor would be willing to purchase shares of Coca Cola (ticker: KO) at $40, but not at $45, selling a put option contract with a strike price of $40 on Coca Cola could be a smart move. If the option gets exercised, the investor has accomplished his goal of entering a position at $40, and he will have received the option premium as a cash payment on top of that. If the option does not get exercised, the investor would at least receive the put option premium, which will provide a meaningful cash income yield as well.

Final Thoughts

Option contracts may not be the right choice for all investors, but income investors should take a look at some option strategies, such as selling cash-secured puts. This strategy allows investors to receive cash income while waiting for a better entry price for a stock they would like to own anyways.