The more stock market volatility increases – like now – the more stock options benefit investors. Especially those selling stock options. Market volatility spikes cause certain stock option values to rise, which makes their selling price richer. Here’s a brief overview of stock options, then back to why they are timely to sell now.
There are two types of stock options: puts and calls. A call option is essentially the right to buy a stock. Oppositely, a put option is the right to sell a stock. You can buy or sell the right to buy or sell. I often use stock options as a strategic way to enter (buy) or exit (sell) stocks. Again, this approach to stock portfolio management is especially effective as market volatility is high. For this month’s column, I will focus on “calls”.
There are critical variables that are necessary to consider with stock options: direction, amount, strike price, and time. First, time. All stock options have a finite “life”, that’s the time they exist until they expire. An option’s life could be one day or over a year. The stated “expiration date” determines the life of a stock option. Direction is just which way the underlying stock goes – either up or down. Now, “strike price”. A stock option’s strike price is the price the underlying stock must reach to cause an option to be “in the money”, and potentially be “exercised” or “assigned”. The amount variable in a stock option refers to the difference between the current market price of a stock and the option strike price chosen. For example, here’s a hypothetical call stock option for Apple stock. A “December 18 140″ would be a December 18 expiration with a 140 strike price. Let’s say at that same time Apple stock is $131.50. In this example, the option is “$8.50 out of the money”; the difference between the stock price per share and the option’s strike price.
One major differentiator between buying and selling stock options is risk. To help explain this key point about option risk, I’ll use call options. Remember, “calls” are the right to buy a stock. Basically, the buyers of calls are risk-takers. They are speculating that a stock will not only go up, but also by a specific amount and in a usually short time frame. They have to be right on direction, amount and time. All three must occur for the call option buyer to have a winning bet. I use the word ‘bet’ to emphasize what buyers of options do. Sellers of stock call options do not take any risk. They are just selling the right to buy their stock. Here’s more on that. Again, a call is the right to buy a stock. You could profit from selling the right to buy. If you already own a certain stock, you can sell the right to buy your stock – and you get paid for that. Say, back to the Apple example, you own 500 shares. You might consider selling your Apple stock at a higher price in the near future. In the example, Apple is priced at $131.50. Suppose you decide you would be happy to sell it at $140 by December 18. Let’s say at this time an Apple December 18 $140 call is $2.00. So, you could sell 5 contracts (each representing 100 shares) for $1,000. Since option prices are quoted on a per share basis, each contract is $2 times 100, valued at $200. What you would have done in this example is collected $1,000 while creating an obligation to selling your Apple at $140 in the next month or so. This does three things at once: increases cashflow from your stock (in addition to dividends), reduces risk, and limits your gain to the strike price ($140 per share).
I stressed the point earlier that increased market volatility can cause stock option values to rise, making them richer and more beneficial for option sellers. As stocks soared from the March market bottom, demand for buying calls – bets on stocks going up – has also soared. As the gambler’s demand for buying calls has jumped, so have the prices of call options. This is good for sellers of those call options. The conservative stock owner can sell rich calls as the speculators make bullish bets. Though I said earlier that call options sellers don’t take any risk, understand that if a stock that you sold a call against should rise above the option strike price, you do not get those gains in your stock. That is called “opportunity cost”. Sticking with the Apple December 18 140 call option sell example, if Apple climbed to $200 by expiration date, you would have it “called away” (sold) at $140. There is a way to undo this, but this is noted to say there is opportunity cost in selling calls.
I first wrote about stock options in my Investor’s Edge column in October of 2018. I made an important point then; I want to reiterate it now. Stock options are not suitable for all investors and they are not ideal for all stocks. Remember the old adage, “There’s no free lunch”. Even now with increased market volatility and rich call options prices benefitting sellers, call and put options require a thorough understanding of their unique variables and potential opportunity costs.
Put and Call options are a proven way to profit from stocks even as the market falls. They work for me and can work for you. Let me know if you have any questions.
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