With interest rates at their lowest point in history, once safe income-producing assets such as 10- and 30-year Treasury bonds have seen their yields plunge to pitiful rates that are just high enough to keep up with inflation.
And while high-quality, dividend growth blue chips (1) such as Pfizer (PFE), Coca-Cola (KO), Procter & Gamble (PG), and Johnson & Johnson (JNJ) are a great way of generating higher yields in this zero interest rate world, many investors are worried that the recent run up in such stocks means they are exposing themselves to larger short-term downside risk.
In other words, fears of a potential dividend stock bubble (2) have many people wondering where they can turn to generate solid returns while controlling downside risk.
Fortunately, stock options offer such investors some useful tools to meet their income, and risk control needs. And unlike what some people may think, not all options are high-risk, leveraged, speculative bets on the short-term movements in stock prices.
Let’s take a look at two low-risk, leverage-free, conservative income-producing option strategies to see how they can be used in concert with high-quality, dividend growth blue chips to help you reach your financial goals in this time of extreme market and interest rate uncertainty.
What are Stock Options?
Stock options are merely contracts in which the writer of the option (i.e. the person selling the contract), commits to buying or selling 100 shares per contract of an underlying stock, at a pre-determined “strike price,” if the share price is above or below that price by the option’s expiration date.
In other words, you can think of them as forms of insurance, in which the buyer of the option guarantees themselves the ability to buy or sell shares at a guaranteed price.
As the writer of the option, you serve as the insurance company, and receive an upfront premium for entering into the contract, and thus either tying up your shares, or your cash, for a predetermined amount of time.
There are Many Different Types of Options Strategies
Options are an incredibly versatile tool, with literally dozens of differing strategies for investors to use in any kind of market scenario, and with various different goals, such as capital gains, income, buying shares at a discount, selling them for a higher profit, hedging downside risk, or using leverage to boost gains.
Here are some common types of options and strategies you might have heard about before:
– Puts
– Calls
– Put spreads
– Call spreads
– Butterfly spreads
– Condor spreads
– Iron Butterfly spreads
– Iron Condor spreads
– Diagonal Call Spreads
– Various combinations of the above
While this list may seem daunting, in reality these strategies are mostly just combinations of the two most basic forms of options: puts and calls.
This article will focus on the two most basic, conservative income strategies based on these two options strategies: selling cash secured puts, and covered calls.
We’ll cover how, when, and who should use them, as well as the potential risks and rewards involved with both. We’ll also take a look at two examples, using two popular blue chip dividend stocks, Pfizer (PFE), and Johnson & Johnson, to show precisely how these strategies work.
For more detailed explanations of these, or other, more advanced strategies listed above you can click here.
Also note that, while buying calls and puts is also something you can do, and in fact is involved with many options strategies, it’s generally something for income investors to avoid, because studies show that about 75% of options expire worthless. In other words, the edge belongs to options sellers (aka writers).
