Stock Options - Basic Strategies for A Lifetime Of Option Investing
From the Bull Market Report Seminar, Vail 1999
Introduction - The Very Basics
• An option is the right, but not the obligation, to buy or sell a stock for a specified price on or before a specific date. A call is the right to buy the stock, while a put is the right to sell the stock.
Buyer and Writer or Seller
• The person who purchases an option, whether it is a put or a call, is the option "buyer." Conversely, the person who originally sells the put or call is the option "seller" or "writer."
Contract -- Premium -- Risk
• 1 option contract controls 100 shares
• The price of the option is referred to as the "premium"
• The potential loss to the buyer of an option can be no greater than the initial premium paid for the contract.
• "Strike price" or "exercise price" - the price at which the option holder may buy the underlying stock pursuant to a call option or sell the stock pursuant to a put option.
• "Expiration date" - options expire on the third Friday of the month.
Call Options vs. Put Options
• Call Options - The buyer of a call option purchases the right to buy 100 shares of the underlying stock at the stated exercise price. Thus, the buyer of 2 IBM May 160 call options has the right to purchase 200 shares of IBM at $160 up until May expiration date.
• Put Options - The buyer of a put option purchases the right to sell shares of the underlying stock at the contracted strike price. Thus, the buyer of one IBM May 160 put has the right to sell 100 shares of IBM at $160 any time prior to the expiration date.
Strategies - Risks and Rewards
• Who Buys Options?* An investor who is very bullish
* An investor who would like to take advantage of leverage with a limited dollar risk
In an example, ZYX is trading at 44 1/4. Instead of spending $22,125 for 500 shares of ZYX stock, an investor could purchase a six-month call with a 45 strike price for 3 3/8. By purchasing a six month call with a 45 strike for 3 3/8, the investor is saying that he anticipates ZYX will rise above the strike of 45 (which is where ZYX can be purchased no matter how high ZYX has risen) + 3 3/8 (the option premium), or 48 3/8, by expiration. Each call represents 100 shares of stock, so 5 calls could be bought in place of 500 shares of stock. The cost of 5 calls at 3 3/8 is $1,687.50 (5 calls x 3 3/8 x $100). Instead of spending $22,125 on stock, only $1,687.50 is needed for the purchase of the 5 calls. The balance of $20,437.50 could then be invested in short-term instruments. This investor has unlimited profit potential as ZYX rises above 48 3/8. The risk for the option buyer is limited to the premium paid, which in this example is $1,687.50. Commissions and taxes have not been taken into consideration in these examples, although they can have a significant affect on the investor's returns.
Had the stock been purchased at 44 1/4 (a cost of $22,125), and it rose to 51, it would now be worth $25,500. This would be a 15.3% increase in value over the original cost of $22,125. But, the call buyer spent only $1,687.50 and earned 77% on his options.
• Who Sells Options?* Put Sellers
* Call Sellers
• Put Writer:* An investor who would like to acquire a position in a particular security, but is willing to wait for it to trade at his desired price.
* Would you rather buy CSCO today (4/5/99) for $113 or 2 months from now for $105
- (May 115 puts @ $10)
Writing A Put
Have you ever given your stockbroker an order to buy a security at a specified price? If you have, you have participated in a waiting game. The stock will not be purchased until it trades at or below your limit price. Instead of waiting for that to happen, you could have sold a cash-secured put. A premium (the price of the option) for selling a put option would be paid to you for accepting the obligation to buy a stock that you want to be a part of your portfolio at the price you select.
If the stock does not drop below the strike price by expiration, the premium will be retained by the seller and another put may be sold. By selling the put, the investor receives the premium while waiting for the stock to decline to the strike or price at which he is willing to own it. Therefore, the cash-secured put is a strategy that may help you accumulate stock at a lower price than where it is currently trading (net cost = strike price - premium).
• Covered Call Writer* An investor who is neutral to moderately bullish.
* An investor who is willing to limit his upside for some downside protection.
* "Cash flow"
NOTE: The covered call strategy may be implemented in Keogh and IRA accounts.
Covered Call Writing
Covered call writing is either the simultaneous purchase of stock and the sale of a call option or the sale of a call option against a stock currently held by an investor. Generally, one call option is sold for every 100 shares of stock. The writer receives cash for selling the call but will be obligated to sell the stock at the strike price of the call if the call is assigned to his account. In other words, an investor is "paid" to agree to sell his holdings at a certain level (the strike price). In exchange for being paid, the investor gives up any increase in the stock above the strike price.If an investor is neutral to moderately bullish on a stock currently owned, the covered call might be a strategy he would consider. Let's say that 100 shares are currently held in his account. If the investor was to sell one slightly out-of-the-money call, he would be paid a premium to be obligated to sell the stock at a predetermined price, the strike price. In addition to receiving the premium, the investor would also continue to receive the dividends (if any) as long as he still owns the stock.
The covered call can also be used if the investor is considering buying a stock on which he is moderately bullish for the near term. A call could be sold at the same time the stock is purchased. The premium collected reduces the effective cost of the stock and he will continue to collect dividends (if any) or as long as the stock is held.
•Credit: because the option sold is priced higher than the option bought.
•Spread: because it's a purchase of one option and the sale of a related option on the same stock at a different strike price.
•Bearish Credit Spreads* uses call options
* profitable if the stock does not increase significantly
•Bullish Credit Spreads* uses put options
* profitable if the stock does not decrease significantly
Making It All Work For You!
•Covered Calls & Credit Spreads* Time is on your side
* "Position trades"
Time and "Position Trades"
It is very difficult for most people over the long-term to make money buying options on a regular basis. The main reason for this is two-fold. When you buy an option with a month or two until expiration, you have to be right in the direction that the stock is going to move AND you have to be right on the timing of the move...that is, it has to move pretty soon or the time value of the option will work against you too much.
When you sell options (ie, covered calls and credit spreads), the strategies tend to be a little more forgiving. This is due greatly to the fact that you will have the time value working for you.
Another benefit of covered calls and credit spreads is that they are what I refer to as "position trades". That is, once you enter the covered call position or the credit spread, generally, you don't need to watch the screen all day. Such is not true when you are buying options. Generally, when you buy options, you want to keep close tabs on it during the day in case it makes a run one way or another so that you can make a move if needed. Thus, the covered call and credit spread techniques fit in to many people's lifestyle much better than other stock option strategies.
Certain of of the foregoing text re-printed herein with permission from the C.B.O.E.
Copyright © 1998 1999 Chicago Board Options Exchange.