The Secret to Life-Changing Income in Retirement

We're stepping it up a notch today...

So far this week, we've covered saving for emergencies, retirement savings, and index funds. Today, we're going to talk about something near and dear to my heart... something that can radically change the way you think about income.

Options.

Don't worry, I'm not going to get too technical today. But I want to explain what options are and then tell you the best way to use them.

To start, an option is a contract that you enter into with someone else.

The value, or "payout," of the contract is derived from the price of the underlying stock. (That's why options are classified as a type of "derivative.")

Now, I doubt many folks reading this are contract lawyers. So it's important to note that these contracts are standardized. There's no negotiating over the terms or conditions. They're all the same. That allows them to be traded quickly in the options market.

So we're dealing with contracts, but we can buy and sell them with ease at the prevailing market price.

Options come in two main varieties: calls and puts. And you can either buy or sell them.

Let's talk about buying and selling first...

These terms often cause confusion because people think of buying and selling stock. In the case of a stock, you need to own it to sell it. But options aren't like that. To reiterate: They are contracts and therefore operate under different rules than stocks. So you can sell one that you don't already own.

If this concept is still confusing to you, here's another way to think about it: When we say we're "selling" an option, we basically just mean we're "writing" an option. In other words, if you want to sell an option you don't own, you are really writing a new contract and putting it up for sale.

Now, let's dive into the differences between call and put options...

A call option represents the right to buy a stock at a specified price in the future.

A put option represents the right to sell a stock for a specified price in the future.

To me, the most intuitive example is buying a put. Put buyers use them as a hedge or as insurance on a stock. That makes it an easy example to get your head around.

Let's say you own stock in a company whose shares trade for $100. You like the company and think its shares will go up. But you know stocks can be unpredictable. Rather than stand fully exposed to the downside, you can buy a put to hedge your investment.

You could buy a put with a "strike price" of $90. And it will cost you $5 (per share). (A strike price is the agreed-upon price at which shares may change hands in the future. This is the price at which a trader can exercise an option.)

Buying the put gives you the right to sell your shares for $90 each, no matter how low the stock's price may fall in the open market. Someone out there sold the put to you, so he's on the other side of the trade.

If the stock stays at $100, you have the right to sell it for $90 to the other guy, though you wouldn't do that... $100 is more than $90, and you'd never willingly choose to leave money on the table. If you wanted to sell shares, you'd just do it in the open market.

You see, the buyer of the put has the right, but not the obligation, to sell those shares. If you want to keep your shares, you can.

However, the other guy – the put seller – is the one with the obligation. For example, say the company's shares fall to $80. You still get to sell them for $90. You can "exercise" your put, and there's nothing the other guy can do about it. He must pay you $90 and take your shares. Factoring in your $5 upfront cost, you are still $5 better off than if you held an unhedged position.

If the stock drops even further to $50... doesn't matter. You still get to sell it to the other guy for $90 (and walk away with $85 after accounting for your $5 upfront cost). You've just protected your wealth. The other guy tried to make a $5-a-share profit in the hopes the stock would continue trading above the strike price, but he ended up losing $35 a share.

Buying a put as insurance is just like the insurance you buy on your home. If your home burns down and is worth practically nothing, the insurance company will give you a check for a certain value. For this peace of mind, you pay a small amount in insurance premium.

To summarize, the put buyer gets protection on his position. He has a floor on his share price. And he has to pay some dollar amount up front, which we call a "premium."

The put seller, on the other hand, gets to collect that premium as income. If the stock doesn't fall, he gets to keep the premium free and clear. But if it does, he must stand ready to buy shares at the agreed-upon price.

As you might know, I love selling options. The key to this is to only sell options on stocks you love and want to own... That way, you can't lose.

Now, while put options make sense as insurance and a hedge, call options work for speculation.

A call buyer has the right to buy shares for a certain price. The call seller must provide those shares at the agreed-upon price.

Let's look at the call buyer here. Say you find a stock trading at $100 a share. You don't own any shares yet, but you think they're bound to rise to $110.

If you're right, you could buy shares and earn a 10% return. But you could buy a call option instead and make a much larger profit...

Say you pay $2 for an option with a $105 strike price. This means that no matter what may happen in the market, you can buy shares for $105.

If shares rise to $110 like you expect, you can "exercise" your call and buy shares for $105 each. You can then immediately sell them in the market for $110. That means you've made a $5-per-share profit. Considering that you paid $2 to buy the option at the start, you've turned $2 into $5... a return of 150% on the same move in the stock.

However, if the stock never trades for more than $105 a share, your option won't be worth anything. You wouldn't exercise your option and pay $105 for shares that trade at $105. You already paid $2 up front, so you'd need shares to rise to $107 to break even.

Can you see the benefit for the call seller (the guy on the other side of the trade)? He collects $2 up front. And depending on where share price ends, there's a good chance he'll keep that money free and clear.

With just these simple option trades, we've got four different bets traders can make...

This table makes it easy to see what sort of bet an option trader is making. A call buyer is bullish on the stock, is paying for the right to buy shares, and has unlimited upside. His downside is limited because he can't lose any more money than he pays out in premiums.

A put buyer, on the other hand, is bearish. He has the right (but not the obligation) to sell shares. And he can't lose more than the initial premium he pays, so his downside is limited.

The more a stock falls, the higher the profits for a put buyer. Since stocks can't drop below $0, the upside is technically limited.

Looking at these potential payoffs, it looks like option buyers with their fantastic upside and limited downside would make for the best trades.

Option buying allows you to earn big gains, but you have to properly predict big moves in stocks within a specific time frame. That's hard to do. So you may win big, but you'll do it less often... far less often than option sellers.

I typically stay away from buying options. It's just too hard of a game to consistently win at. Most option buyers I know end up eventually losing their shirts.

Instead, if you sell options on stocks you love, you can pocket income month after month. The gains you collect are never going to wow anyone. But the income you pick up can seriously change the way you live in retirement.

Consider giving this strategy a try.

What We're Reading...

• Buying versus selling options: Which is riskier?
• Something different: The huge success of the Tamagotchi.

Here's to our health, wealth, and a great retirement,

Dr. David Eifrig and the Health & Wealth Bulletin Research Team
January 3, 2025