What is an option?
In a nutshell, an option is a contract that gives its holder the right (but not the obligation) to buy or sell a certain item at a specific price on or before a specific date… and while an option contract can be written for almost any asset class imaginable, our focus here will be on options that are written for specific stocks and/or baskets of stocks (such as those that make up the S&P 500 Index, for example).
Options that give their holder the right to buy a specific stock (or index) are called call options, and options that give their holder the right to sell a specific stock (or index) are called put options.
Whenever stocks (rather than indices) are involved, all of the major U.S. exchanges have agreed that each contract represents the right to buy or sell exactly 100 shares of the underlying stock… and trading of partial contracts is never allowed.
In addition to identifying whether it is a right to buy or to sell, each contract also lists the specific price (called the strike price) at which the holder of the option can sell the underlying security, as well as the date at which the contract expires (called the expiration date).
On the major U.S. option exchanges, strike prices for stocks are usually set at multiples of $5, though some stocks also have options with strike prices that are multiples of $2.50… and due to demand from traders, many stocks now instead have strike prices in other increments as well.
In addition to this standardized practice for strike prices, the exchanges have also uniformly agreed that the expiration dates for regular “monthly” stock options will always fall on the third Friday of the month named in the contract (however, in recent years, “weekly” options have also started traded on number of the more active stocks). However, it should be noted that index options usually expire around the same time of the month as stock options; however, each index option has its own set of rules, so be sure to seek clarification from your broker before entering into any index option trades!
Which months can you buy options for?
Though there are also “weekly” options available to trade these days, when it comes to the “monthly” options, they are always available for the month that contains the upcoming expiration date, the month after that, and then a series of months that are spaced three months apart.
When options are first made available on a stock, that stock gets assigned to be on either a January-, a February-, or a March-cycle… and this designation determines which months will be used for options going forward (a company on the February cycle, for example, will always have the options available for the following months: a) the current month of expiration, b) the next month after that, and 3) some combination of February, May, August, and November).
In addition the short-term options that trade on this cycle, some stocks also have LEAPS traded on them. LEAPS is an acronym for Long-term Equity AnticiPation Securities, which is just a fancy way to say “longer-term option.” The life of these contracts is often measured in years rather than months, and they always expire on the third Friday of January in the year specified by the contract.
Who sells options, and how are they priced?
In addition to buying options, it is also possible for both individuals and institutions to sell (write) options; however, much of the writing is done by institutions and professional investors rather than individual investors (who tend to like prefer to take the gambler’s side of the trade, i.e. to buy the options rather than sell them).
When it comes to option prices, the primary determinant of an option’s price is the perceived likelihood of the option being exercised on or before its expiration date. Of course, there are numerous factors that influence this variable: the amount of time left on the option contract, the distance the stock is from the strike price, and the chance of the stock traveling that distance before the option expires are three of the big ones. In addition to these three primary forces, there is also a dose of supply-and-demand thrown into the mix, and thus option prices also tend to be influenced by the level of demand (or lack thereof) seen for them in the marketplace.
Of these factors, the passage of time is the only one that investors can predict with 100% certainty, and thus it plays one of the largest roles in determining option prices (options with more time left on them will have a higher price than options with similar strike prices but less time remaining). It is important for both sellers and buyers of options alike to realize that all options lose a portion of their value as time goes by, and this “time decay” accelerates as the option gets closer and closer to expiration.
Though a discussion of it is beyond the scope of this discussion, investors who are interested learning more about how the pros value options are encouraged to investigate a nifty bit of mathematics called the Black-Scholes Equation.
What are the “basic” option trades?
Though more advanced option traders love to spend their time talking about spreads, butterflies, strangles, naked calls and naked puts (actual things – not porn for option junkies!), collars, condors, and all sorts of other fun and exciting strategies that can be employed when trading options, it is important to gain a basic understanding how options work in their simplest form before tackling some of those more advanced strategies.
The following four actions represent the most common “first option trades” that investors new to options trading often make:
What it is: Buying a call gives the holder of the contract the right to purchase 100 shares of stock at a certain price on or before a certain date.
When to use: Investors would execute this strategy if they were bullish and felt that a stock going to move up towards (and hopefully past) the strike price before the expiration date.
How money can be made: money is made if the stock rises quickly enough.
How money can be lost: as time goes by, the option loses time value (shorter duration = shorter time premium); if the option is below the strike price at expiration, it results in a 100% loss of capital.
Potential risk: limited to 100% of investment.
Potential reward: unlimited.
What it is: Buying a put gives the holder of the contract the right to sell 100 shares of a stock at a certain price on or before a certain date.
When to use: Investors would execute this strategy if they were bearish and felt that a stock going to move down towards (and hopefully past) the strike price before the expiration date.
How money can be made: money is made if the stock falls quickly enough.
How money can be lost: as time goes by, the option loses time value (shorter duration = shorter time premium); if the stock is above the strike price at expiration, it results in a 100% loss of capital.
Potential risk: limited to 100% of investment.
Potential reward: unlimited*
*in reality, the reward is bounded by the magnitude of the strike price itself, since no stock can fall below $0.
What it is: selling a call obligates the writer of the contract to sell 100 shares of stock at a certain price if the holder of the contract exercises their right to buy on or before the expiration date.
When to use: Investors would execute this strategy if they were bullish enough on a stock to own it but bearish enough to think it was not likely to rise above the strike price before the expiration date.
How money can be made: money is made if the stock rises slowly (or not at all), thus causing the option to lose time value; if the stock is below the strike price at expiration, the option expires worthless and the seller keeps 100% of the premium received for writing the contract.
How money can be lost: the stock rises quickly; if the stock rises above the strike price, the seller of the contract may have their stock called away from them (thus resulting in a “missed opportunity” cost as the rally in the stock is missed out on).
Potential risk: limited to the losses that might be attained through depreciation in stock price (less the premium for writing the contract).
Potential reward: limited to the difference between the stock price and the strike price at the time the contract is written, plus the premium received for writing the contract.
Please visit Covered Call Basics on our website for additional information on this strategy!
What it is: selling a put obligates the writer of the contract to purchase 100 shares of stock at a certain price if the holder of the contract exercises their right to sell on or before the expiration date.
When to use: Investors would execute this strategy if they were interested buying a particular stock at a price lower than the market price but were not sure if the stock would ever drop below that price.
How money can be made: the stock stays above the strike price and the option loses value due to time decay; the stock is above the strike price at expiration, the seller keeps 100% of the premium received for writing the contract.
How money can be lost: money can be lost if the stock falls too quickly.
Potential risk: limited to the difference between the stock price and the strike price at the time of expiration (less the premium received for writing the contract).
Potential reward: limited to the premium received from the writing of the contract.
Unlike the writing of naked (uncovered) calls, which has limited profit potential and virtually unlimited risk, the writing of covered calls is one of the most conservative ways to participate in the options game.
In order to write covered calls, one must not only own the stock that they will be using to collateralize (“cover”) the option, and they must own it in round lots of 100 shares for each contract they intend to write.
For example, an investor who owns 350 shares of a stock would only be allowed to write three (3) covered calls (against the first 300 shares of the position) since the last 50 shares would not represent enough collateral to cover another contract (each contract represents 100 shares).
Though the strategy of writing covered calls against an existing position can be used effectively in any market environment, it is most often employed by investors who are bullish on a stock’s long-term potential but neutral or bearish about the near-term outlook.
In addition, while the financial impact on one’s portfolio turns out to be the same regardless of the reason why they decided to write covered calls against their stock, investors often approach this strategy from one of two angles (or perhaps a combination of the two under certain circumstances).
Reducing Downside Risk With Covered Calls
The first way to look at covered call writing is as a way to reduce downside risk.
For example, let’s pretend Nervous Nate owns 100 shares of XYZ Corp., and true to his reputation, he starts to get nervous about next month’s earnings report a full seven weeks before it is going to be released. Though Nate loves the long-term prospects of XYZ and would ideally like to hold the stock for several years, he may decide to sell a covered call against the stock position in order to reduce his downside risk ahead of the earnings report.
And, getting more specific, let’s assume that XYZ is currently trading at $31.50… and that, if he chooses to, Nate can write a covered call with a strike price of $35 that expires in just under two months for $1.50 (really $150, since each contract represents not 1, but 100 shares).
If Nate somehow finds the courage to just ride out whatever fate befalls the stock after the earnings report (i.e. he decides not to write the call), the possible outcomes for his portfolio over the next two months can be summarized as follows:
• if the stock is below $31.50, he will have lost money relative to where things are today (and will still own the stock)
• if the stock is above $31.50, he will have made money (and still owns the stock)
• if the stock is still trading at $31.50, he will have broken even (and still owns the stock)
On the other hand, if Nate decides to “play it safe” and writes the call after all, his list of possible outcomes looks like this:
• if the stock is below $30 (not $31.50 anymore – Nate has bought himself an extra buck-fifty of downside protection!), he will have lost money (but still owns the stock)
• if the stock is above $30 (not $31.50!) he will have made money… and if the stock is still below $35, he will continue to own the stock (a wonderful source of worry for Nate – and what would he do with himself if he didn’t own any stocks to worry about?!)
• and, if the stock is above $35, he will no longer own the stock because it will get called away from him at that price – but Nate won’t mind because he made $350 on the stock over those two months and pocketed $150 from writing the call, giving him a gain of almost 16% in a two month period (which makes Nate smile… even if only for a moment or two).
Generating Income With Covered Calls
The second way to look at covered call writing is as a way to generate income from an asset that is already owned.
For example, let’s say that Income Irene also owns 100 shares of XYZ Corp. (again selling at $31.50), and she, too, comes to the realization that she can write a covered call with a strike price of $35 that expires in just under two months for $1.50.
Just like above, If Irene does not write the call, her possible outcomes are:
• stock below $31.50 = lost money (but still owns the stock)
• stock above $31.50 = made money (but still owns the stock)
• stock at $31.50 = broke even (but still owns the stock)
On the other hand, if Irene goes after the income and writes the call, her possible outcomes are:
• if the stock is between $30 and $35 at expiration, she will still own his stock and will have pocketed the $150 she collected for writing the option on stock she was going to own anyway for those two months
• if the stock is above $35, she will have pocketed the $150 as income and realized another 11% appreciation on her stock investment over those two months. Of course, she no longer owns the stock, but Irene is content because she realizes that a 16% combined return in just two months isn’t too shabby (even if she ends up owing some of the gain in taxes)
• if the stock is below $30, she will have lost money (but still owns the stock)
Conclusions About Covered Call Writing
As you can see, even though their reasons for writing covered calls are different (“hedging” vs. “income generation”), the possible financial outcomes for Nervous Nate and Income Irene are the same… and hopefully this helps reinforce the idea that regardless of which angle an investor chooses to approach the strategy from, it really just boils down to “a numbers game” in which an investor simply aims to figure out which set(s) of numbers most closely addresses their needs and desires when it comes to balancing risk and reward.
In addition, however, if you plan on writing calls against stock that you really are hoping to hold for years, it is very, very important to keep in mind that one of the biggest risks when writing covered calls is that your stock might get called away from you in the early stages of a bull move for the stock, thus resulting in a huge “missed opportunity cost” as the stock continues to rise. If this is of concern to you, you may want to consider keeping a small pool of money handy that can be used to repurchase (probably at a loss) any contracts you have written that appear to be headed for exercise by their holders (which, in many ways, is not a bad way to go since you get to write-off the short-term loss on the option while holding on to your stock that you would otherwise owe capital gains taxes on if it is sold).