Creating regular passive income through the stock market can be an uphill battle in today’s unpredictable financial landscape. With the Federal Reserve insinuating a potential cut in interest rates to help the economy reach a soft landing, investors are looking more toward dividend stocks to create income. But the average yield of an S&P 500 stock is an anemic 1.32%, not enough for those looking for growth and yield out of their investment portfolios.
Options trading is one such platform that solves this problem of income. Though most retail investors avoid options trading as they are supposedly complex, they actually provide many strategies that can greatly enhance the income from dividend stocks. As a matter of fact, options can transform a modest-yielding stock into a strong income-generating asset.
In this article, I will reveal one of the simple but powerful options strategies: the so-called covered strangle. Applied rightly, it is able to quadruple your cash income from stocks like Pepsi, turning a mediocre dividend yield into a formidable stream of passive income. Now let’s break it down and see exactly how this works and how you can do it yourself.
Understanding the Covered Strangle Strategy
The covered strangle is a well-known options trading strategy where you sell a call option and a put option on an underlying stock that you own. This is one of the ways you can generate more income from the premiums received with the sale of these options in addition to the dividends paid by the stock.
When you sell a call option, you are obligated to sell your stock at a predetermined price, known as the strike price, if the stock rises above that price level on or before the expiry date of the option. On the other hand, selling a put commits you to buying more shares of that particular stock at a pre-determined price in case the price of the stock falls below that level.
How It Works: A Pepsi Example
Now, let me give you an example of how this covered strangle works. This one is on PepsiCo – ticker: PEP. You imagine that you have 1,000 shares of Pepsi, at $171.28. The annual yield on Pepsi is around 2.89% and translates into $4,950 in annual income for 1,000 shares. That is above average compared to the S&P 500, but whoop-de-doo, right?
This will be a covered strangle strategy that will work wonders for improving your income. Here’s how:
Selling Calls
The stock is trading at $171.82, and you sell 10 call options with a strike price of $180, or about 5% higher than the current level. The price of one call option is $10.45. One option contract represents 100 shares; thus, selling 10 contracts would bring in $10,450 in income.
Selling Put Options
At the same time, you sell 10 put options with a strike price of $160—which is about 5% below the stock’s current price. Each put option fetches $7.60, thus adding $7,600 to your kitty.
Overall Cash Flow
By doing both of these trades, you see a net cash inflow of $18,050. That’s on top of the $4,950 you got from the dividend for an overall income of $23,000, which is not too terrible over and above the income coming off the dividend itself.
Risks and Rewards of the Covered Strangle
Like any trading strategy, the covered strangle carries its risks and rewards, which, when understood, can help in applying the strategy successfully.
Rewards
- Higher Income: As you saw with the Pepsi example, it showed how much higher in income the covered strangle could give you. You don’t only get revenue off of the dividends, but you also pull in extra income off of the premiums of the options sold.
- Flexibility: This strategy allows you to tailor your strike prices according to your risk tolerance. If you are comfortable selling your stock at a slightly higher price, then you can choose higher strike prices for the call options and it will still yield substantial income.
- Market Adaptability: The covered strangle applies to all types of market conditions. This strategy is modifiable based on a market that is bullish, bearish, or neutral in order to maximize returns.
Risks
- Call Obligation: You will need to exercise or sell the Pepsi stock above $180 if it were to be above that amount at expiry. While you are assured of profit under this circumstance, you will lose further gains in case the stock price goes even higher.
- Obligation to Buy: You could be obligated/required to buy, at the prevailing price, an additional 1,000 shares if Pepsi’s stock falls below $160. This will necessitate your having adequate capital and being comfortable owning the additional number of shares of the stock.
- Possible Tax Implications: Writing call options and having shares called away could result in higher capital gains taxes. It is important for investors to consider such aftershocks of this strategy before employing it, particularly when one has a relatively low cost basis in one’s shares.
Why the Covered Strangle is One of the Smart Passive Income Strategies
For investors who want passive income, the covered strangle does bring a number of great advantages to the table.
- Larger Return: This is the main reason investors like the covered strangle—not because it’s a play with great upside, but rather because it really boosts the income generated by the dividend-paying stock. In the Pepsi example shown, note that the dividends and options premiums can quadruple your annual income.
- Defending Risk Management: Unlike more aggressive options strategies, the covered strangle is a pretty conservative option. You have the ability to restrict your risk while taking in large premiums by choosing strike prices 5% above and 5% below the current price of the stock. One of the primary benefits assured by the covered strangle is the consistency of the return therein. By selling options that are a year from expiration, you ensure a regular and predictable stream of cash flow—one which you can reinvest or use to help subsidize your living expenses.
How to Use the Covered Strangle to Your Advantage in Your Portfolio
If you feel ready to actually begin implementing the covered strangle strategy, here’s what you must do:
- Start by choosing a reliable dividend-paying stock whose options are available. Those are usually large stable companies, like Pepsi.
- Identify Strike Prices: It makes sense to identify call and put options with strike prices that are at least 5% or more away from the current stock price. This will ensure that options expire worthlessly, letting the premium either be retained wholly or in greater measure.
- Sell the Options: Utilize your online brokerage to sell both the selected call and put options. You should ensure that you sell the same amount of contracts that equate to the quantity of shares that you own. Example of call option selling 10 contracts for 1,000 shares of stock.
- Trade Monitoring: Observe the movement of the stock price as the options will approach expiration. This is when you’ll nearly certainly take action, buying back the options to avoid assignment if the stock price is hovering near the strike prices.
- Realign Annually: Go back and reassess your situation at the end of the year. If the options expired worthless, sell another round of options for in this case, the next year, moving right along and continuing the passive income development cycle.
Conclusion
The covered strangle is a simple, yet powerful options strategy that turns a humble dividend yield into a far more meaningful source of passive income. You can quadruple your cash flow by writing both call and put options on a stock you already own—as recently shown with Pepsi. It does more than make much-improved income; it’s a flexible, adaptable approach to investing in today’s unsure market. Options Secret for Producing Smart Passive Income is more than just a name; this is an extremely tried-and-tested approach that will help your financial goals achieve remarkable success. Be it options trading that is new to you or you are an experienced trader, a covered strangle presents a smart way of enhancing the income of your portfolio with effective manifold risk management. Just start implementing this strategy today and watch your passive income grow by leaps and bounds.