CALLS

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:

Options trading can be described as a parallel to owning and leveraging a rental property. One owns an asset that she is willing to leverage with a tenant occupying the rental property in exchange for monthly rent/income. In options trading, one owns shares (rental property) and she is willing “leverage” these shares for “rent” or in the case of options, premium income. In this scenario, the owner of the rental home gives the tenant the option but not the obligation to buy the property if he/she desires based on an agreed upon price and date. In options trading, the owner of the stock is providing the option to buy the underlying security at a specified price by an agreed upon date. From the renter’s perspective, if the home value is increasing and the housing market is strong, the renter would exercise this option and elect to buy the home. In the case of options trading, the renter of the stock (option owner) would exercise the option to buy the shares if the shares rise significantly. In this scenario, the tenant witnessed home values increasing and decided to exercise the option to buy and capitalize on the rent they were already paying into the property. Conversely, the renter of the shares witnessed the stock appreciate and decided to exercise the option to buy the stock and capitalize on the “rent” he had already paid into the option contract. As the owner of the property/stock, the ideal scenario is to own the property/stock and continuously collect rent/premiums on a monthly basis without relinquishing the property/stock. Thus, the owner of the stock/rental property 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 asset 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. 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. From the stock owners perspective, he/she is selling the right for someone to buy the shares at $105 a month from now when the current price is $100. 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.

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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