Options are contracts that give the buyer the right to buy or sell shares of a stock. Options give the option contract holder great leverage. A little money can control a large amount of stock. Buying an option requires a much smaller outlay of money than purchasing the actual shares of stock and therefore reduces the risk of losing money. Stocks are traded on a stock market, and options are traded on an options market. Playing the options market is kind of like placing bets on what the stock market will do. Options can be used in both conservative (low risk) and speculative (high risk) strategies. They can be used to protect stocks you own from declining prices, generate income from currently owned stocks using “covered call options,” position yourself to possibly buy a stock you want to own but at a lower price and benefit from the rising stock price of a high-priced stock but without tying up a lot of money by purchasing the actual shares.
Strategies Using Options
Buy options on stocks you believe will go up, but whose shares are expensive and beyond your budget. Suppose there is a stock and your research brings you to the conclusion that this stock’s price should increase in the next few months. But the problem is that the stock price is high, and this would require you to come up with a lot of money to purchase the stock. You can still benefit by the stock’s rise in price by purchasing call options on the stock, rather than purchasing the actual stock itself. The holder of a call option contract has the opportunity, but is not obligated, to purchase the underlying stock. Therefore, the strategy in this case is to buy call options and then sell them when the stock goes up in price, as the value of the call options themselves will also increase in value. When purchasing call options, be sure to pick an expiration date far enough out to allow the stock’s price sufficient time to move, and always take the premium cost and brokerage commission fees into consideration to ensure a profitable trade.
Limit financial risk while having unlimited profit potential by using call options. Let’s look at an example of this strategy. Suppose you believe company XYZ’s stock price will go up, and it’s currently trading at $30 a share. You purchase a call option with a strike price of $30 and an expiration date of several months out. Assume the option costs you $100 (which represents 100 shares of stock). It would cost you $3,000 to buy 100 shares of XYZ (not including a brokerage commission). But that would put $3,000 of your money at risk. By purchasing a call option, you have limited your risk to only $100. During the time you hold the option, assume the stock price rises to $33. As the holder of the call option, you can exercise your right to buy 100 shares of XYZ at $30 per share. Then you can immediately turn around and sell the stock, making a $200 profit ($3,300 less $3,000 for purchasing the stock and less the $100 premium to buy the call option). You made $200 while only risking $100! Furthermore, your upside potential was not limited. The stock could go even higher, and you’d make even more profit. Had the stock not risen above the $31 per share price, you would have let the option expire worthless, and you would have limited your risk to only $100. Suppose you had actually purchased the stock rather than purchased a call option, and the stock dropped to $25. You would have lost $500!
Use “put options” as a protective strategy for stocks you hold in your portfolio. When you hold a particularly risky stock (one that can quickly swing high or low in price) or during times when the stock market as a whole is experiencing a lot of volatility, put options can act as insurance against downside risk. Put options are the opposite concept of call options. A put option holder has the right, but not the obligation, to sell a stock he or she owns at a set price within a given period of time (before an “expiration” date). Suppose you own 100 shares of company XYZ, which you purchased for $25 a share. The next few months are expected to be a volatile time in the market, so to protect your investment, you purchase a put option with a $25 strike price and an expiration date of several months out. The cost (premium) to purchase the put option is $100 ($1 per share, and one option contract represents 100 shares of stock). If the stock drops below $25 at any time before the expiration date, you can exercise the put and sell the stock for $25 a share, no matter how low the actual stock price goes. The “protective put” acts as an insurance policy, protecting against loss below $24 in this case (taking into account the $100 premium paid to buy the put). A cost of $100 to insure a $2,500 investment is a great insurance strategy using put options!
Generate income from stocks you own using the option strategy of “writing covered call options.” One covered call contract will typically generate between $50 and $100 in a very short time, usually in only one, two or three months, on stocks you own in your portfolio. Selling a call option is called “writing.” The strategy for making money is to write “covered” calls, that is, to sell the rights to purchase shares of stock you own (shares that you have “covered”), at a specific price on or before a certain expiration date. Let’s say you own 100 shares of XYZ that you purchased for $19 a share for a total cost of $1,900. For the sake of simplicity, we won’t factor in the cost of any broker commissions (which usually run around $5 to $10 for online brokerages). Since one option contract represents 100 shares of stock, you must own a minimum of 100 shares of a stock to write one covered call option. If you own 200 shares of a stock, you can write two covered calls and so on. When you buy a stock or option, you pay the “ask” price. When you sell a stock or an option, you receive the current “bid” price. Stock charts show these figures (cboe.com has free option charts). Since you bought the stock at $19, you wouldn’t mind selling it for $20 a share, as you would make $100 on the deal. Suppose the bid price for an expiration date of two months from now for a $20 strike price is paying $2.17 (the “premium”), for a total of $217 for one option contract (because one contract covers 100 shares of stock). This money is called the “premium.” So you sell a call option on the stock you own or have “covered.” Excluding commissions, you would receive $217 in your account immediately! It doesn’t matter if the stock goes up, down or sideways in price. You have $217 free and clear, forever. By writing the covered call, you are giving the right for someone to buy your 100 shares of stock for $20 a share between now and the expiration date. You have just made money for selling that right! If the stock goes up over $20 before the expiration date, someone (we won’t know who, as transactions are all done electronically) will buy your option. When that happens, you’ll receive $2,000 for selling your shares of stock. So, you will have made $217 for writing the covered call, and another $100 for selling the stock. That’s a $317 profit (less commissions). That’s almost a 17 percent profit in two months! If the stock doesn’t go above $20 during those two months, you get to keep the $217 premium and you get to keep the stock in your portfolio. You can turn around and write another covered call for two or three months out again! In this way, as long as you aren’t “called out,” you can “rent” your stock several times a year to generate extra income. In the event that the call option is exercised, you still walk away with a handsome profit.