By now, the thought of earning passive income had to cross your mind at least once. After all, the idea of it is pretty enticing, but where to begin? Real estate comes to mind, although the steep barrier to entry might be a bit daunting for some. Selling a product on Etsy, eBay, Amazon? Certainly works if you have talent and skill or happen to target a niche market, or better yet – both. You should still be able to point to at least half a dozen options (if not, hit pause on this post and read 100 Side Hustles) and among them is investing in stocks and funds.

No, we’re not talking about day-trading. There are enough apps, Betterment, Wealthfront, Stash, Robinhood, Acorns, etc. offering the hands-off approach with far lower initial capital requirement and a far higher rate of success. All great points of entry for anyone looking to “set it and forget it” or invest without comprehensive understanding of the stock market.

On the other hand, if you care to spend a weekend or two on Investopedia, you will not only be more well-versed in investing than 80% of your peers, but will start to approach equities more creatively, which is exactly what we’ll try to accomplish in the latter part of this post. I should also take a minute to note that I am not a licensed tax professional or financial adviser so the following should be taken with a grain of salt and used merely for general reference.

So here we are — great. What exactly is our game plan?

Collect premium on the passing of time until we enter a stock position at a desired price or exit out of a current position at a price that brings us a predetermined return that we are happy with. Forget chasing gains and arbitrage for a moment. Technical analysis is for suckers and so is attempting to time the market that’s run by bots and algorithms.

Why our strategy makes sense.

Entering or exiting positions using options forces us to take a systematic approach to trading stocks that’s less prone to emotional mishaps. We are not focusing on maximizing our gains from a stock sale. Instead we are setting a realistic goal for ourselves as far as our required and regularly-generated return from selling options – let’s call it $150-$200/mo on a $10,000 portfolio which equates to an extremely generous pre-tax annual return of 18-24% excluding compounding. Yes, along the way we may also enter and exit out of long stock positions, but we’ll look at this merely as a bonus or bi-product of our strategy that helps maintain our option-trading cycle.

Time is money — capitalize on it. In fact, make that your new habit: what did I earn for my time today, this week, this month? It could also be time with your family, a new client, a new learned skill. Any of these answers are fair game, so long as the answer isn’t “nothing.” As far as stocks are concerned, 95% of the time we spend “waiting” for the price to move up or down so that we can enter or exit a position. Selling options allows us to monetize this waiting game, even and especially if the stock price doesn’t move.

Generate passive income. Yes, this exercise is somewhat time-intensive at first, but later on it should take no more than 1-2 hours a month – I’d say that’s pretty passive. The reason I insist on calling it “income” is because it’s regularly-generated and you control (and can rely on) the amount and frequency.

Getting down to business – our criteria is as follows:

  1. Sell options on stock where implied volatility is decreasing and choose strike prices outside of 1 standard deviation from current stock price for a given option term. Implied volatility is something that’s given to you on the trading platform and you can read more about it here. Selling options outside of the “high likelihood” channel of price movement increases the chances of your sold options expiring out of money allowing you to pocket the premium and move on with your life.
  2. Sell put options on stock you may wish to own and see value in at the strike price, and always have enough cash in your account to cover the purchase of stock if your put options get assigned. This brings you two scenarios, one where the option expires and you profit from the premium and one where the option we sold is exercised giving us shares of a stock we don’t mind owning and consider to hold value even at it’s current price.
  3. Sell only covered call options. The difference between the call strike price and your cost basis should meet your required return on the stock position. Selling covered calls is important as you don’t want to fall into a trap where you must sell shares of stock you don’t own a.k.a. unintentionally shorting a stock which could lead to unlimited losses. And yes, with this move we’re effectively limiting our potential gains on a stock, but as mentioned before the goal is consistently meeting our target returns not chasing maximum returns that may or may not come.
  4. Last but not least, you should be able to fund your account with roughly 100x the average share price of stocks you intend to sell options on. This means that with an account of $10,000 you probably won’t be able to do much with Apple (NYSE: AAPL) trading at $190/share but could look at stock like GoPro (NYSE: GPRO) currently at around $6. Even though you don’t need much capital to trade options themselves, eventually options you’ve sold may get assigned and you will need to produce the underlying shares of stock to sell or have enough cash to acquire the shares from someone else. And don’t forget, you’re not working with single shares but multiples of 100, since each option contract typically corresponds to 100 shares of underlying stock. Always track and remain within your liquidity bounds

Example time.
Sonos (NYSE: SONO) is currently at $10.50/share. You want to buy 500 shares at $10 and exit at $12.50 to lock in 15% gain. Let’s forget commission cost for simplicity’s sake and assume the stock’s implied volatility has been decreasing and expected price movement is fairly modest.

You can obviously submit a $10 limit order. Instead of waiting for the order to get triggered we sell five 30-day put contracts at $0.25. That places $125 in our account immediately. If a month from now the price dips below $10 we may also become proud owners of 500 shares of SONO. If not – great, we got our $125 and are moving on toward our next option trade.

Ok, now let’s say the price does fall to $9.50. Since this is below the $10 strike price of the puts we sold, it’s likely the options may get assigned, meaning the buyer takes advantage of the put option and you now are obligated to purchase 500 shares at $10. But they are trading at $9.50… BREATHE! We are not day-trading and in it for the long haul, but now you see why it’s important to trade options on stock you wouldn’t mind holding for a little while and see long-term value in.

Enter call option. Since you have 500 SONO shares at your disposal you can comfortably start selling five covered call contracts that are currently trading at $0.20 on a 30-day term with a $12.50 strike. We immediately put $100 in our pocket ($0.20 option premium x 5 contracts sold x 100 shares per contract).

If SONO price remains constant (or falls) you keep holding on to the shares and pocket the premium from this and subsequent monthly or weekly sales of call options, while we wait for the rally. Alternatively let’s assume SONO pops to $15/share and now the call options we sold get assigned. Since our calls have a strike price of $12.50 that’s the most we will get for our stock which still gives us a profit of $2.50/share (we bought at $10 when our put option got assigned) or a $1,250 total gain plus the $100 initial premium from the sale of a call option plus the $125 premium from the sale of the put option in the very beginning of this example for a total gain of $1,475 over this two-month period.

Cool story brah, but does this even work? So far it has for me with a reasonable enough return (4% over the course of 11 weeks) to want to continue following this strategy until a better one comes along. Without doubt it’s not for everyone, certainly not someone who’s never traded stocks on their own before. Nevertheless, it’s an idea I find worth exploring further as a creative ancillary source of regular earnings.

Tried it out? Find it interesting? Think its total and utter garbage? Hit the comments section below.