Profiting in Small-Caps Whether They Go Up, Down, or Remain Flat

Bryan Hayes
8 min read

In This Article:

It’s not often that we can make money even when our underlying investment goes down in price.

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

There is no need to worry 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 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.

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.

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