CALL OPTION BASICS

I’ve written many articles highlighting the advantages options trading and how this technique, when deployed in opportunistic or conservative scenarios may augment overall portfolio returns while mitigating risk in a meaningful manner.

The Question:

As stock positions fluctuate, why not leverage these assets and collect residual income on a regular basis?

Overview:

Selling covered calls is a means in which one can leverage long stock positions to extract residual income on a regular basis via premium income. The owner of the shares sells the right the option buyer to buy the shares at an agreed upon price by an agreed upon date. From the option buyer's perspective, if the shares increase in value above the agreed upon price, then the option buyer would exercise the option and elect to buy the shares. Why buy the shares on the open market at a higher price when you can buy them from the option seller for a lower price (the agreed upon strike price)?

As the owner of the long stock, the ideal scenario is to continue to own the stock will collecting premium income on a monthly basis without relinquishing the stock. Thus, the owner of the stock allows for an upward buffer of price appreciation since the agreed upon price would be higher than the current market price. In this scenario, as market conditions decline, move sideways or appreciate to a certain degree the stock will be retained while collecting residual income.

Example:

Selling a call option will take on the obligation to sell the shares of interest. For instance, he/she is taking on the obligation to sell shares at $105 a month from now when the current price is $100. The seller of the call contract believes the shares will not appreciate beyond the $105 level prior to expiration. Thus the owner of the shares would collect the option premium and retain the shares while the call buyer would lose the premium paid and end up without any shares. In this case, the call option seller collects a premium from the call option buyer and makes money while leveraging the shares. 

The buyer of the call contract believes the shares will rise above the $105 level within this time frame. If the shares appreciate above $105 per share, the owner of the shares would relinquish shares to the call buyer. Why buy the shares above $105 on the open market when the call option buyer can buy them from the call seller for $105? This is effectively a residual income attempt via leveraging the shares on a monthly basis. In this case, the call option seller collects a premium from the call option buyer and relinquishes shares at the strike of $105 per share.

A Few Characteristics to Keep in Mind for Covered Call Options Trading:

1. Strike price: Price at which you can buy the stock (buyer of the call option) or the price at which you must sell your stock (seller of the call option).

2. Expiration date: Date on which the option expires

3. Premium: Price one pays when he/she buys an option and the price one receives when he/she sells an option.

4. Time premium: The further out the contact expires the greater the premium one will have to pay in order to secure a given strike price. The greater the volatility the greater the time premium received for covered call writing.

 

5. Intrinsic value: The value of the underlying security on the open market, if the price moves above the strike price prior to expiration, the option will increase in lock-step.

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