Why Would I Trade Options?
Options are versatile. You can trade options to mitigate your risk of loss on a stock you already own or you can trade options to increase your leverage and potential returns.
Example #1 – Mitigate your risk, Limit your Profitability (Conservative Position):
You own 100 Shares of XYZ that is currently trading for $10. You believe the market may have a small downward swing in the near future, but you want to keep your stock because you want to obtain long-term capital gain tax treatment on your gain. Instead of selling the stock, you sell an option. You would sell a “CALL” to someone. You would sell someone the right to BUY your stock at a certain price. You decide to write a “CALL” to sell your stock to someone for a “strike price” of $13 a share that expires in 3 months. You receive $.90 per share for this option.
Things to know:
- Your option immediately results in cash in your account, instantly.
- Options are sold in units of 100 shares of stock. One option gives the rights to buy or sell 100 shares. Therefore everything is multiplied by 100.
- This type of specific example is called a “COVER CALL” because you are “covered” by the securities you have in your possession – if someone calls the stock at $13 a share – you have it.
We should analyze what Example #1 really does to your security. This was a little hard to write, so I thought I would just give potential results of the example #1 to help you flush out why options can be beneficial or harmful.
Potential Results of Example #1:
- Stock Dumps to $7 a share, option never gets executed: You lost $3 on your shares, but got $.90 an a share on an option = –$2.10 a share, but this would have been $3.00 without an option so your option was a gain of $.90 a share.
- Stocks go up to $12.90 a share, option never gets executed: You made $2.90 on your shares and also received $.90 a share on an option = +$3.80 a share
- Stock goes up to $13.50 a share, option gets executed: The person who bought your option “CALLS” or “EXECUTES” the option to buy your stock for $13. You receive $13 a share for your stock, a $3 increase on the stock from when you sold the option and you receive $.90 a share on an option = +$3.90 a share – If you wouldn’t have sold the option you would just have the stock that would have an appreciation of $3.50 a share, still less than what you earned with the option, you netted +$.40 on the sale of the option. (but you might have lost your long-term capital gains treatment depending on when it is executed and how long you have owned the stock)
- Stock goes up to $22 a share, option gets executed: The person who bought your opinion takes your shares for $13 a share when they are trading for $22. You receive $13 a share, a $3 increase plus the $.90 per share on an option = +3.90 a share, but if you would have not stock the option you could have kept the stock which is now worth +$12.00 more a share. This option netted you –$8.10 a share. You got destroyed… or did you? You still made 39% in 5 months.
- A little more complicated: Stock goes down to $7 a share, and the option is now only worth $.40 instead of $.90, and you decide you want out of the option. You can buy back the option for $.40 and now have effectively mitigated $.50 of your $3 a share loss (you received $.90 and gave back $.40 but no own has any options to “CALL” your stock). Furthermore if you wanted to, you could re-issue the same option as before with a lower strike price of say $9 or $10 instead of $13 (which would be selling for more than the $.40 you just paid to buy your option back fundamentality)