The good thing is that many advanced option traders have an options strategy which enhances passive income; it requires merely a minor portfolio adjustment. Such a simple options strategy boosts the yield on dividend-paying stocks such as Pepsi to as much as four times what you can earn by holding such stock. It’s called a “covered strangle,” and the strategy lets you vastly ramp up your cash via selling both call and put options against stocks you currently own or are willing to buy.
In this article, we are going to show you how you can create smart passive income using this options strategy on Pepsi stock. Be you a complete beginner in options trading or an experienced investor—this might just be the game-changing approach that will bring in long-awaited income with generally a low-risk profile.
Low Dividend Yields in the Stock Market
With interest rates still likely to fall, fixed-income investments such as bonds and savings accounts will continue to yield less. For that reason, many investors will begin to eye dividend-paying stocks as a source of income. Unfortunately, using dividends alone might not be such a hot proposition.
The average yield of an S&P 500 stock currently stands at an anemic 1.32%, nowhere near what is needed to satiate the hunger-for-income investors who also want growth from their portfolios.
Even the best dividend-paying stocks, for instance, Pepsi and its 2.89% annual return, are dwarfed by the returns available through other investment vehicles, including money market funds currently offering more than 5% yields. In this light, it is easier to understand why a dividend investor should feel disappointed, particularly when higher income flow becomes necessary to satisfy desired objectives.
Strategy of the Covered Strangle-a Solution to Boost Your Income
All this leads us to the options market, and more precisely, to the covered strangle strategy. Such a strategy presupposes the simultaneous selling of both a call option and a put option on one and the same stock, which one either possesses or is ready to possess. The aim here is to obtain premium income from the sale of those options, thus raising the cash inflow that one receives from the dividends of this very stock. Here’s how this works, step by step, using Pepsi as the example:
Call Option:
A call option is an option that entitles the buyer to buy your stock at a certain price—the so-called strike price—for a certain period. Within the covered strangle strategy, you sell a call option that is above the current market price of the stock, by at least 5% higher.
Put Option:
In buying a put option, you sell the right to sell your stock at the price of purchase for any time during the duration of exercise. You should sell a put option that has its strike price below the current market price of the underlying stock (at least 5% lower).
The result is that you collect premiums from selling both the call and the put, adding a significant boost to the income you already receive from dividends.
An Example: Pepsi and the Covered Strangle Strategy
Take, for instance, Pepsi stock, which, as of January 19 of the previous year, traded at $171.28 per share. In this case, its dividend yield stands at 2.89% while 1,000 shares would therefore earn an approximate dividend yield of $4,950 within the year. Though this position is above average in the S&P 500 Index, it is still low compared to what money market funds are currently offering.
Here’s how you could use the covered strangle strategy to significantly ramp up that income:
Sell Call Option:
You sell 10 call options on January 19, 2023, with an $180 strike price; if the value of Pepsi is currently $171.5, this option is at a strike price of about 5% higher than the current price. The premium for this option stands at $10.45 per share or $10,450 of immediate cash income for 100-share lots.
Sell a Put Option:
You sell 10 put options with a $160 strike price about 5% below Pepsi’s current price, simultaneously. The premium for this option is $7.60 a share, adding another $7,600 in cash income.
Selling both options, your total cash flow for the year would be $18,050; if you “reinvest” that sum with Pepsi dividends at $4,950, your total income goes to $23,000. At this point, that’s more than quadruple the income you would have made by holding the stock for its dividend.
Advantages and Disadvantages of the Covered Strangle Strategy
Benefits:
- Higher Income: As you can see, the covered strangle has the potential to greatly increase the income you achieve from your investments. On the Pepsi example, you would have created more than a fourfold greater cash flow than simply holding the stock for its dividend.
- Flexibility: This will be especially appealing to an investor who is indifferent to selling his stock at a higher price or buying more shares at a lower price.
- Limited downside risk: The risk involved in this strategy is limited when compared with all other options strategies since you are prepared for selling your stock at profit in case the call option is exercised or in buying more stock at a lower price when the put option is exercised.
Risks:
- Stock Sale Requirement: If Pepsi’s stock price indeed rose above $180 at the expiration date of the options, you would be required to sell your shares at that price and perhaps miss out on further gains.
- Purchase Obligation: If the stock of Pepsi falls below $160.00, you will be obliged to purchase more shares at that level, which may not be what you want at that time.
- Capital Gains Tax: If you sell your stock through the call option, this might fall due, decreasing the overall profitability of the trade.
Conclusion
The covered strangle is one of the major solutions to the ultimately intelligent passive income streams of investors. By selling both call and put options on stocks you already own or are willing to own, you can substantially augment the income beyond what dividends alone could provide.
As shown with Pepsi, this strategy can more than quadruple your cash flow and really is a game-changer for your investment portfolio. With this covered-strangle strategy, you can exploit the full potential of your dividend-paying stocks while managing risk in an environment where traditional sources of income are gradually becoming less appealing due to falling yields. Thus, if you’re still seeking ways to enhance your passive income in the stock market, such an options strategy could turn into the missing piece of the jigsaw.