Why Work When You Can Trade Options All Day?
Wednesday, January 18th, 2012When most people begin to invest they start with mutual funds or ETFs (exchange traded funds). Perhaps advancing into stocks after a while. Finally, with some experience and confidence under their belt, they try options. Options trading is not for the feint of heart. They can be quite volatile. There is a chance to double your money in a short period of time, but there is also a chance of losing it all. But with some education under your belt and a disciplined approach you can do quite well.
There are two kinds of options: calls and puts. In both cases they have a ’strike price’ and an ‘expiration date’. But a call option represents the right to buy stock, while a put option represents the right to sell stock. In both cases the buyer has the right, but not the obligation, to exercise his or her option. Likewise, the seller of the option has the obligation, but not the right, to deliver (in the case of calls) or receive (in the case of puts) stock if it is above (calls) or below (puts) the strike price.
The most common reasons for options trading are: (1) as insurance (puts), (2) as speculative tools to take advantage of near term rising prices (calls) or falling prices (puts), or (3) as an income oriented strategy that takes advantage of the time decay.
Options are different than stocks in the sense that for every dollar someone makes in options, some other person loses a dollar. It is possible to make money as a buyer or a seller of options if you are correct on timing and direction. However, the fact that most options held until maturity expire worthless tips the scales in favor of the sellers over the long term.
The most popular option-based strategy is called “covered call”. In fact, Charles Schwab has stated that 84% of their option enabled accounts will trade covered calls. For every 100 shares of stock you own you can sell 1 call option and receive premium (money) today. If the stock finishes below the strike price by expiration day then you keep that money (and your stock) and can sell another call for the following month. If the stock finishes above the strike price then you have a choice: either buy the option back (if you want to keep the stock), or let it get called away and receive the strike price per share for your stock.
Selling a call option on stock you already have puts a cap on your upside. You will never receive more than the strike price per share (although you can set the strike price to whatever value you like). The plus is that you receive premium (money) the day you sell the option, and that premium can be used to offset any decline in the stock. So you get some downside protection in exchange for putting a cap on the max you can make. In many cases you can make money even if the stock declines, as long as it goes down less than the premium you received.
Investing with covered calls is not difficult. It is usually the first strategy people learn when they begin with options. It can be time consuming, though, if you don’t have a good covered call screener to help you. A good screener will scan the universe of possible trades and alert you as to where the high yield opportunities are. The alternative of using a spreadsheet to calculate possible trades is, at best, incomplete and laborious.
Born To Sell, www.borntosell.com, is a web site about covered call trading. Use this link to go to Born To Sell’s web site on covered call trading.