I’ve mentioned options before when I talked about short selling. There are advanced option strategies that I won’t get into here, but there is also a beginner option strategy that is a nice way to protect your portfolio. You should definitely learn as much as you can about options before getting into buying or selling option contracts. A great resource is the Chicago Board of Options Exchange which is not only the largest options exchange but also provides webinars, video classes and an option blog written by real option traders.
What is an Option?
An option is a derivative which is a big word that describes how an option functions. The value of an option is ‘derived’ from the underlying asset. So a stock option has value based on the value of the stock. When the stock price moves, the price of the option moves. This type of derivative is a financial instrument with no tangible value except what the option contract states. For example, when you buy a stock, you are buying ownership in a company. When you buy or sell an option, you are entering into a contract. So let’s look at what you get when buying or selling an option.
The Long and Short of It
There are two types of options contracts, calls and puts. A call gives the buyer the right to buy the underlying stock at a specific price. A put gives the buyer the right to sell the underlying stock at a specific price. On the other side, a call gives the seller the obligation to sell and the put requires the seller to buy at a certain price. There are various levels of option buying and selling that your broker would have to approve you for. The first level of options trading is covered calls. This is level 1. Each time you write a covered call, you will receive a premium for taking on the risk that your stocks might get called away.
How Does a Covered Call Option Work?
Instead of going into detail on all of the possible option strategies, I will focus on a call and how it works for the buyer and the seller. The buyer of a call chooses a strike price, that is the price that triggers the option. If a stock is trading at 12 dollars and the option strike price is 13 dollars, the buyer of the call will not be able to exercise their call until the price of the stock gets to at least 12 dollars. If the price of the stock continues to go higher, the buyer of the call has already locked in their purchase price at 13 dollars. They had to pay a small premium in order to get this option.
From the seller’s perspective, they received the premium from selling the option. So if the buyer decides to cash in, the seller of the call option must follow through with what the contract states. In this case, they must sell the underlying stocks for 13 dollars a share. So why would anyone ever write/sell a call option? Time is on their side. Based on the simple fact that most options expire worthless, the seller of the option can take advantage of the fact that they will receive the cash premium without having to deliver the actual stocks. And in this way they can create income from their portfolio.
Are you using covered calls in your portfolio?
Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options (ODD). Copies of the ODD are available from your broker, by calling 1-888-OPTIONS, or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois 60606.