Stock Options Basics, Part 3 Selling Options

In this series I’m covering the absolute basics of options. Note that I am not recommending the use of options is any way. I am simply trying to make you aware of how options work to increase your knowledge it the area of investing.

Part 1 of this series covered basic terminology and a couple of examples. Part 2 covered what makes options valuable.

Today I’d like to cover selling options.

Options cost money, because they have a time value and at times an intrinsic value as well. The cost of an option, however, doesn’t just magically disappear when you purchase the option. An option is a financial contract between two parties, and the premium paid for the option actually goes to the other party.

In the first part of this series I used discussed the price of two options as of this writing:

• CALL Jan 09 INTC $15: $0.74  (january call option on intel corp stock at a strike price of $15/share. the options costs 0.74/share, or $74/option which represents 100 shares)
• PUT Jan 09 INTC $15: $0.74  (january call option on intel corp stock at a strike price of $15/share. the options costs 0.60/share, or $60/option which represents 100 shares)
• The current price of Intel stock is $15.12/share.

Let’s talk about some choices we have given this information:

• If we think Intel’s stock price is going to go up between now and when the option expires, we could buy a call option. If it goes up enough we would make some money. The call option is barely in the money, meaning that the strike price is $15 but the stock is already at 15.12/share. This means that there is 0.12/share of intrinsic value, and the rest (0.62) is time value. Therefore the stock would have to rise to 15.74 for us to break even at the expiration date.
• If we though the price of INTC was going to go down we could purchase a put. The put option is currently out of the money (by 0.12). This is one of the reasons why the put option costs less than the call option, because there is no intrinsic value in the put option.

Since an option is a contract between 2 parties though, what does this look like from the sellers point of view.

Selling A Call Option

Let’s say you have 100 shares of INTC that you wouldn’t mind selling for $15/share. You wouldn’t mind keeping the stock either, but if you sold it at $15/share that would be fine with you. Rather than selling it today for $15.12/share, you could sell the Jan 09 15 call option. You would recieve $74 as a premium and then you would wait to see what happens. If the price of INTC stays above $15, then you’ll need to sell your shares and will get $15/share (or $1500 total). You’d end up with $1574. This is obviously better than $1512 if you had sold the shares outright.

What you’ve really done is exchanged any potential upside on your stock for $74, and that $74 has reduced your downside risk. If INTC jumps to $100/share five minutes after you sell your option, you’ll get your $74 but the buyer of the call will get ($100-15)*100 -74 = 8500-74 = ~$8426. However, if your stock goes below 15 you’ll have received $74 and will still have your stock. Then, if you want, you could write another call.

Selling a call when you own the underlying security in sufficient quantity is called selling a “covered call”. It’s “covered” because you already own the underlying stock. If you didn’t own INTC and sold an INTC call it would be referred to as selling a “naked call”. This is a much more risky proposition, because theoretically if INTC surged to $1000/share or more you would have to buy the share on the open market. This could cost you $1000*100 = $100000 in this example, and yet you only earned $74 for selling the naked call. Not too smart. Since a stock can theoretically rise infinitely high, selling a naked call can have infinite risk.

Selling covered calls, however, are considered by some to be low risk and can offer advantages in certain situations. I am not recommend this as a strategy per se, but some use it regularly

Selling A Put

Let’s say you’re willing to buy 100 share of INTC today, but you’re willing to wait for the price to drop. You could sell the Jan 09 put at a strike of $15. If the stock price drops below $15 you’ll end up paying for 100 shares at $15/share. That might be fine with you. You will also have received $60 as a premium, which is kind of liked getting 4 of those shares for free! If the stock price dropped to $10 though, you’d still have to pay $1500 for your 100 shares, even though the current market value of those shares would be $10*100 = $1,000. In this case you would have overpaid for the shares versus the current market price. You’d still have the option premium though, but $60 is not enough to offset the $500 difference between what you paid for each share and the current market price. If the stock price continues to rise then your option will expire worthless and you’ll still have your $60.

This type of transaction is called a ‘naked put’ because the seller does not have a short position on the stock. The risk to the seller is that the stock could go to zero, which means that he/she would still have to pay $1500 for 100 shares of stock that are essentially worthless. While this does not represent unlimited risk like selling a naked call, there is still the potential for loss.

Summary: selling calls and puts can offer investors advantages in certain situations, and can be a source of additional cash flow if the markets perform as expected. In my opinion, however, this is speculation and not investing, and there is a great potential for loss when using any options strategy.

If You Liked This Post Then Please Check These Out...

• Stock Options Basics, Part 4 Special Situations
• Stock Options Basics, Part 2
• Stock Options Basics, Part 1
• For The Love Of Dividends
• I Don’t View Commodities As Investments

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