How to Produce Weekly Income from Technology Stocks
Tech stocks aren’t generally known for their income-producing capabilities. Even with several of the well-known tech giants initiating dividends in the last year, big tech simply doesn’t have the ability to provide substantial and consistent income.
But one simple option strategy has the power to do just that. In fact, this strategy has consistently produced above-average returns with relatively low risk.
Before we delve into the strategy itself, let’s review some option basics.
Option Basics – A Refresher
Options are standardized contracts that give the buyer the right – but not the obligation – to buy or sell the underlying stock at a fixed price, which is known as the strike price. A call option gives the buyer the right to buy a stock, fund, or index, while a put option gives the buyer the right to sell the same.
The investor who purchases an option (whether a put or call) is the option buyer, while the investor who sells a put or call is the seller or writer.
Forget about complex mathematical formulas or equations. Over the years I’ve found that the more complicated a strategy is, the less likely it will work over the long-term. We want to employ a strategy that has a history of profitability and is easy to follow.
Options consist of time value and intrinsic value. In-the-money options consist of both components. At-the-money and out-of-the-money options consist only of time value.
At options expiration, options lose all time value. When we are short an option, the time value of that option becomes profit at expiration regardless of the price movement of the underlying stock or ETF.
Become Your Own Bank
Most investors are not familiar with the concept of selling option premium to generate cash income. Selling option premium is a very simple but lucrative income strategy. When you sell an option, cash equal to the premium is immediately credited to your brokerage account.
Unlike a traditional stock dividend, you don’t have to own the stock on the dividend date to receive a quarterly dividend and you don’t have to wait a year to receive a 2% or 3% annual dividend yield.
The key to selling option premium to generate cash income is to make sure the option you sell is ‘covered’. In this example, we’ll be using what is known as a buy-write or covered call strategy. In this strategy, we buy in increments of 100 shares of a stock or ETF and sell a related call option. As options cover 100 shares of the underlying security, we want to make sure that we sell 1 call option for every 100 shares purchased.
Weekly covered calls are initiated by buying 100 shares of a stock and selling 1 weekly call option. As noted previously, when you sell an option, cash equal to the option premium sold is immediately credited to your brokerage account. This cash credit reduces the cost basis of the stock and reduces the overall risk of the trade. The great advantage to selling weekly calls is that you get to sell 52 options a year.
This strategy incurs less risk than owning the stock outright, but has the potential to deliver returns far in excess of simply owning the stock.
Because the short option is ‘covered’ by the purchase of the stock or ETF, this strategy incurs limited risk. The covered call strategy can profit if the market goes up, down, or remains flat and gives us an edge in producing consistent returns during any type of market condition.
Ideal Strategy for Today’s Volatile Markets
Selling option premium is a great strategy for profiting during hostile market conditions. Weekly options amplify this strategy as we get 52 opportunities each year to generate income as opposed to just 12 with monthly options.
Let’s take a look at an actual trade example. Tech stocks have led the way during this latest bull market rally. The ProShares UltraPro QQQ ETF TQQQ gives us levered exposure to this group and is a good candidate for our strategy.
With TQQQ trading at 63.61, the June 14th 64-strike call is trading at 2.11 points and is an out-of-the-money option consisting of only time value. When you are short an option, the time value portion of an option becomes profit as the time decays to zero at expiration. At option expiration next week, the time value of this option becomes profit regardless of the price movement in the TQQQ ETF.
Added Dimension of Profitability
Purchasing just 100 shares of the TQQQ ETF and selling the 64-strike call equates to a cost of only ($6,361-$211) $6,150. We can see a risk/return analysis of this trade below:
Image Source: Zacks Investment Research
The table above displays the risk/reward profile for this trade. The TQQQ ETF is currently trading at $63.61 (orange box). We are selling 1 June 14th 64-strike call at 2.11 points (brown box), which is the option premium and is credited directly to our brokerage account. Since options account for 100 shares of the underlying stock, the total cost for this covered call trade is $6,150; our breakeven price is $61.50 as we can see in the yellow highlighted box.
The top (blue) row in the lower section shows the performance of the TQQQ ETF based on different percentage scenarios at expiration. The bottom (purple) row shows the corresponding percentage return for our covered call trade.
If the TQQQ ETF remains flat at $63.61 upon the weekly option expiration, the 2.11 points of time value in the 64-strike call becomes profit as the value of the option goes to zero. We would realize a 3.4% return in this scenario.
If the TQQQ ETF increases in price at option expiration, we still collect the 2.11 points in time premium profit. The short option may show a loss if TQQQ increases above the 64-strike price, but this loss is more than offset by a gain in the ETF. At option expiration, an upward move in the TQQQ ETF would equate to a 4.1% gain in our weekly covered call trade.
If the TQQQ ETF decreases in price at expiration, we collect the 2.11 points in time value as the short option goes to zero. The $211 profit could be offset by a loss in the ETF price depending on how far the ETF declines.
- TQQQ remains flat at option expiration = +3.4% return
- TQQQ increases in price at option expiration = +4.1% return
- TQQQ decreases -3% at option expiration = +0.3% return
When you buy a stock or ETF at a discount via the sold option premium, you can profit if the underlying security increases in price, remains flat, or even declines from your entry point. This results in a much higher probability that the trade will be profitable. It’s a big reason why this option income strategy has a huge advantage over a stock purchase strategy.
Cash-on-Cash Return
As stated above, each call option covers 100 shares of the underlying stock or ETF. Purchasing 100 shares of TQQQ at the current price of $63.61 and selling 1 of the 64-strike calls at 2.11 would cost $6,150 to initiate this covered call trade. If we were to rollover the short options weekly and receive a similar premium, we’d have the potential to collect $10,972 over the next year ($211 x 52). Receiving $10,972 in cash over the next year would result in a 178% cash-on-cash return ($10,972 cash income / original $6,150 covered call cost = 178%).
If you receive a 178% cash-on-cash return, a lot can go wrong and you could still profit.
- The underlying ETF can decline substantially and you could still profit from the trade
- If you have bad timing on entering the trade or encounter volatile price swings, you can still profit
- This gives the buy-write strategy a huge advantage over simply owning stocks outright
Bottom Line
There aren’t many times when we can profit even if our investment goes down in price. The buy-write strategy offers very attractive returns and very low risk making it one of the best overall strategies for investors.
This strategy can be profitable in positive, sideways, or even slightly downward-trending markets. This allows us to maintain our positions through volatile market environments, when normally we would be stopped out of our position. The strategy incurs less risk than owning stocks while also having the potential to produce enhanced gains.
I think the above analysis demonstrates why the covered call strategy should be a part of every investor’s portfolio!
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ProShares UltraPro QQQ (TQQQ): ETF Research Reports