The other day I was talking with a good friend named Adam about options trading. Adam use to work for a pension fund, but now crunches housing data for a think tank in Washington, D.C. When it comes to investing, he is one of the smartest guys I know, and he’s done very well for himself. Anyway, he described for me a simple options trading strategy he uses involving call options that I want to share with you.
Before I get to the options strategy, let me first say that I’ve never dabbled in options. Until recently, I viewed options as extremely risky and pointless for a buy and hold investor. That will change in 2010 for several reasons. First, options don’t have to be risky. Like most investments, it depends on what you invest in and what investment strategy you pursue. Second, a lot of money can be made with options trading. Of course, it can be lost as well, which is why I’ll move cautiously into options. I’m not going to sink a large chunk of our portfolio into a complex options trade. With that said, let’s move to covered calls.
A call option is a contract between two parties to buy shares at a specified time and price. The buyer of a call option gets the right, but not the obligation, to buy shares of a stock held by the seller at a given price. And call options also have a time limit. If the buyer does not exercise the option within the given time limit, the call option contract automatically expires. A single option contract overs 100 shares of the underlying security.
An example will help explain how call options work. Let’s assume that company XYZ is trading at $40 a share. A call option contract might price at $42 for the next month at a cost of $1.50 per share (I’m making the numbers up, of course, but it should give you an idea). This means that the buyer is getting the right, but not the obligation, to buy 100 shares of XYZ company for $42 a share within the next month. The cost of the option contract is $1.50 a share, or $150 ($1.50 x 100 shares).
If the price stays flat or goes down, the buyer of a call option won’t exercise the option. On the other hand, if the price goes up over $42 a share, the buyer will exercise the option.
My friend Adam regularly sells call options. Recently he bought ETF shares in silver and has been selling short term calls. Because the price of silver has remained relatively flat, he’s collected the option contract price and kept his shares in the ETF. It’s kind of like renting out your shares and giving the renter an option to buy at an agreed price.
So what are the risks? The primary risk is that the value of the security will go up substantially, and you will lose out on the gain. In our example, if the share price of XYZ company shot up to $50, you would still be required to sell the stock at $42. You wouldn’t “lose” money in the sense of a cash outlay, but you would obviously be selling stock for less than it’s worth. On the upside, if you think the price of the security will remain stable, it can be a great way to generate passive income off of your stock holdings.
To learn more about options trading, I’ve signed up for an account with OptionsXpress. You can open an account without depositing funds, and then a host of tools and resources become available for free. We published a review of OptionsXpress today, which provides more information on what the online options broker has to offer.