Looking for Income? Boost Your Payout With Probabilities
Everyone wants and needs income, whether it’s from working, in retirement or from trading. It’s a sought after source that provides us with not only what we need, but also with what we want.
In today’s world of low – and in some instances negative – interest rates, finding that income is becoming harder and harder. Making it even more difficult is the risk associated with finding that yield. No longer can we receive sizable income from what many consider “risk-free” Treasury bonds, nor can we count on the banks to provide us with a stable of income on even high-balance accounts.
Many in the industry call it reaching for yield, meaning investors are forced to buy riskier assets in order to get a similar yield to its previously less-risky counterpart, or they are forced to buy assets at a higher valuation in order to get the same yield they used to get at a lower valuation.
This reach for yield has left many investors less certain and has caused them more worry as a result. I certainly don’t like having to buy more bonds to generate the same income, nor do I like to buy stocks with a far higher valuation in order to get the same dividend yield.
But income goes beyond stocks, bonds and the interest generated in banking products. Thankfully, there are also options.
Like the reach for yield issue, lower volatility has also crimped the returns one can generate in the options market. Traders can repeatedly generate income via the options market on a weekly, monthly or quarterly basis. However, when volatility is low (like the current environment), option premiums are also low. While lower premiums do lead to lower income, that doesn’t mean it’s a worthless endeavor.
One problem investors face on a daily basis, but particularly in regards to the reputation of options, is risk. Many investors shy away from selling options because they are perceived as risky, despite a vast majority of options positions expiring worthless to the buyer, entitling the seller to a full profit.
Before we get into all the buying and selling, let’s backpedal a bit. Blindly selling options leaves investors exposed to risk should the underlying security move against their position. Indeed, selling options blindly is risky.
But when an investor combines options selling for income with the three probabilities system developed by OptionParty, the odds tilt heavily in their favor. The three probabilities include probability of profit, probability of target return and probability of total loss. To learn more about these three probabilities, read about it here.
Investors generate income by selling options – they can sell cash-secured puts or naked calls, but less risky strategies come in the form of covered calls, bear call spreads and bull put spreads.
Investors will sell these options for a net credit, money that goes into the investor’s account, and will remain there until the trade either expires or is closed. The goal is for the value of the options to decrease leading into expiration, allowing the investor to pocket a profit
Let’s use an example:
We’ve been following shares of Western Digital (WDC) and want to establish a neutral to slightly bullish strategy. We will do this by selling put options, in what is known as a bull put spread. Our desired minimum return is 5% with an expiration sometime within the next four to five weeks.
The trade requires us to sell the October 14th $46 put and buy the October 14th $44.50 put for a net credit of $0.09. Given that it is mid-September, investors will have roughly four weeks to wait out the trade, and should Western Digital fail to close below $46, the investor will realize their full profit potential.
Currently, there is roughly an 89.4% chance the stock will do just that – close above $46. Should it do so, our trade will hit our minimum target return of 5%. Further, this trade has an 89.6% probability of profit, meaning the trade will generate a profit of $0.01 or more.
Pretty good odds, right? For every ten trades we perform in this manner, roughly nine of them will generate a 5.3% return. Too good to be true? Yes and no.
While the odds do appear quite favorable, the risk of maximum loss, meaning the trade results in a full loss for the investor, is somewhat high at 6.4%. If you were to go to the bank and the manager said they will pay you a 5% return on your money this month, but there’s a 6.4% chance you’ll lose it all, would you still make the deposit?
Some investors might, but they don’t have to take on that much risk.
That’s why probabilities are so important. In the scenario above, we have a nine-in-ten chance of generating our specified return, but a 6.4% chance of total loss is a bit startling. So how about this one instead:
By selling the October $72/$67 bull put spread on the iShares Real Estate ETF (IYR) for a net credit of $0.27, we not only have slightly better odds of hitting our minimum return, but also have a higher probability of profit.
In this case, the trade will generate the same 5.3% return as the first one should the stock close above our short put strike price of $72. However, rather than absorbing the 6.4% probability of maximum loss, this trade carries a maximum loss risk of just 1%.
Despite the lower odds of total financial failure, our odds for profitability did not diminish. Instead we have a 91.6% chance of hitting our minimum return of 5%, as well as a 92.4% probability for generating some form of profit.
By using probabilities, we can take what many would consider a good trade and turn it into a great trade. Too often, investors act on emotion, rather than relying on the odds. But it’s when one tilt the odds in their favor, rather than in the market’s favor, that profitability really has a chance to shine.