The Hidden Risk
of Option Income Trading

Traders of iron condors, covered call writers, and sellers of naked puts all have one goal in common: option income.

Can you blame them? After all, even when traded conservatively, certain option trading strategies can still yield income returns significantly higher than those investments traditionally available to fixed income investors.

On the surface, it's a no-brainer. Would you rather have a 3% annual yield from a dividend paying stock, or the possibility of a 3% (or more) monthly yield from writing covered calls?

I certainly have nothing against option income. I've personally enjoyed reasonable success with all three option income strategies mentioned above. I believe that trading credit spreads for income, when done so in an informed manner and with an emphasis on risk management, can provide outsized annual returns.

But I also believe that there's a hidden risk involved in this approach that any potential income trader would do well to guard against.



Options, Income, and . . . Trouble?

Take what follows with a grain of salt. My position here isn't backed up with exhaustive research and reams of statistics. Consider my position to be one of opinion and perspective rather than one of irrefutable logic and fact.

From my perspective, the biggest risk of trading options for income is if that income is needed or expected to be used as current income. That is, if it's needed to cover your current expenses.

Whether you find yourself attempting to fund a traditional retirement with option trading income strategies, or whether you're hoping that you can generate enough income from options in order to be able to afford to quit your job and take early, early retirement (i.e. the real American Dream), you may be setting yourself up for disappointment.

I've written about this elsewhere. I call it the Myth of Monthly Cash Flow. In short, it comes down to this: it's next to impossible, and highly unrealistic, to expect both high yield and consistent returns (at least in the short term - but more about that in a bit).

Why?

Option income, while it can be very lucrative, is fleeting. If you put yourself in a position where you depend on income from monthly credit spreads, you must recognize that there will be months that you lose.

Not only do losing months eliminate that month's income, in some situations the losses will be equivalent to having to "pay back" income from previous months.

Additionally, income from options is irregular. There's just no way that the Market is so predictable that you can target and achieve a predefined amount of income month in and month out.

And the last thing you want to do is to get desperate enough to lower the quality standards of your trading and begin chasing premium.

If you must spend the income generated from your option trading strategies, I would advise that you do so only partially. Accumulate and retain as much of the income as you can so that it can act as a buffer against inevitable setbacks.

There's nothing wrong with taking two steps forward and one step back. But if you consume what you produce during those forward steps, any subsequent step backward reduces your principal.



Dividends Aren't Just for Financial Nerds

In contrast to option income, dividends produced by high quality companies, are real. They may not yield a lot (not at first anyway), but they generate income you can count on and budget with.

And never underestimate the power of quality dividend growth investing over time. The results, in both bull market and bear market alike, are staggering.

Some might advocate a kind of blended portfolio where half your holdings are in fixed income or dividend paying stocks, and the other half is used to generate income through trading the credit spread of your choice.

If you're drawn to that approach, by all means give it a whirl, but to me it's a divide and conquer strategy - with the object getting divided and conquered being your portfolio.

A more creative solution is to employ a variety of customized option trading strategies (collectively known as Leveraged Investing) designed to lower the cost basis on your long term dividend paying stocks. These perpetual "rebates" or "partial refunds" are reinvested in one form or another into more shares of high quality dividend payers.

And when you learn to track and calculate your option returns in terms of an annualized rate, you really begin to understand what a profound impact these low risk, short term option trades can have when it comes to enhancing your long term portfolio.

Additionally, if you can also reinvest your dividends as well, you'll really turbo charge your portfolio and future income stream. But the great advantage of Leveraged Investing is that even if you spend your dividends in the here and now for current living expenses, the reinvested option income has a similar effect to reinvesting your dividends.



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Warren Buffett Zero Cost Basis Portfolio Current Equity Holdings:

KO - 100 shares
JNJ - 25 shares
GIS - 25 shares

Open Market Purchase Price: $7326.58

Less Booked Option Income: $4450.74

Tot. Discount: 60.75%
Adj. Div. Yield: 7.96%

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