OPTIONS
IN OPERATION
This newsletter for
October 2017 will take a look at common Call and Put Strategies that a stock investor
may employ in his or her portfolio.
ANOTHER MATRIX
Investors buy or sell options because of their beliefs about the future direction of stock prices. (There are other strategies that seek to earn money from the non-movement of the underlying stock, but that is a topic for another month. The matrix below correlates future belief about stock prices with some common option strategies.
BASIC OPTION STRATEGIES
If an Investor owns ICBM stock and:
1. Investor thinks Stock may rise somewhat or
maintain its current price: Sell Call.
This Strategy is called selling a “Covered Call.” It is a covered call because the option investor owns the underlying stock. If the stock behaves as the investor believes, the investor will receive a premium for selling the Call and will pocket the money from selling the premium.
2. Investor is concerned Stock will fall: Buy Put.
ANOTHER MATRIX
Investors buy or sell options because of their beliefs about the future direction of stock prices. (There are other strategies that seek to earn money from the non-movement of the underlying stock, but that is a topic for another month. The matrix below correlates future belief about stock prices with some common option strategies.
BASIC OPTION STRATEGIES
If an Investor owns ICBM stock and:
1. Investor thinks Stock may rise somewhat or
maintain its current price: Sell Call.
This Strategy is called selling a “Covered Call.” It is a covered call because the option investor owns the underlying stock. If the stock behaves as the investor believes, the investor will receive a premium for selling the Call and will pocket the money from selling the premium.
2. Investor is concerned Stock will fall: Buy Put.
This Strategy is
called buying a Protective Put. Owning the Put will give them the right to
exercise the option and sell the stock at the Put Strike Price. Also, the value
of the Put will rise so the Investor may close out the position and make money
on the position.
COMMON STRATEGIES
Numbers 1 and 2 are commonly used. The analysis below will expand upon these strategies and the assumptions that underlie them.
Selling a Covered Call. This is an income generating strategy that a stockholder might use if they believe the stock price will remain steady or fall a small amount. The stockholder must also be ready to sell their shares if the stock rises or buy back the Call at a higher price. Jane owned 100 shares of ICBM. She felt that ICBM stock might fall or stay about the same. She did not think that the stock would rise, but if it did, she was willing to sell her ICBM stock if she was exercised. She had bought it at $40 and it was currently selling at $52. She sells a Covered Call at $55 and gets a $100 premium. Jane read that selling Covered Calls was a way to generate a little more money from a stock that she would be willing to sell anyway.
If Jane is right about ICBM falling in price or staying the same, she will keep her stock and the $100 Call premium. If she is wrong and ICBM goes up to $55 or beyond, she will have to buy back the Call at a higher price (lose her premium) or have the Cal exercised and lose the stock. She will make $15 per share from the sale of the stock and keep the $1 premium. (55 Call Strike Price - $40 basis on stock = $15 gain on ICBM share).
The downside for Jane is that if ICBM shoots up to $70, she will miss out on the price increase beyond $55, the Strike Price of the ICBM call. In summary, the assumptions behind a Covered Call sale are:
1. The belief that the Stock will fall somewhat or stay the same. (If you think it will fall a lot, you should sell it!).
2. A willingness to sell the stock at the Strike Price of the Call or buy back the Call at a higher price than which you sold it.
Buying a Protective Put. This is a common protective strategy to protect a stockholder from fall in the stock price. If Jane holds ICBM and is concerned that it may fall, she has two choices. She can sell the stock outright right now or buy a Put. Jane still likes ICBM’s prospects for the long term. To protect herself from a short-term price declines, she decides to buy a Protective Put. ICBM is currently trading at $52 and Jane buys a Put with a Strike Price of $50. If ICBM falls to $50 or below, Jane can exercise her Put and sell ICBM for $50. She can also sell the Put at a profit.
MORE SPECULATIVE STRATEGY IN A FALLING MARKET
COMMON STRATEGIES
Numbers 1 and 2 are commonly used. The analysis below will expand upon these strategies and the assumptions that underlie them.
Selling a Covered Call. This is an income generating strategy that a stockholder might use if they believe the stock price will remain steady or fall a small amount. The stockholder must also be ready to sell their shares if the stock rises or buy back the Call at a higher price. Jane owned 100 shares of ICBM. She felt that ICBM stock might fall or stay about the same. She did not think that the stock would rise, but if it did, she was willing to sell her ICBM stock if she was exercised. She had bought it at $40 and it was currently selling at $52. She sells a Covered Call at $55 and gets a $100 premium. Jane read that selling Covered Calls was a way to generate a little more money from a stock that she would be willing to sell anyway.
If Jane is right about ICBM falling in price or staying the same, she will keep her stock and the $100 Call premium. If she is wrong and ICBM goes up to $55 or beyond, she will have to buy back the Call at a higher price (lose her premium) or have the Cal exercised and lose the stock. She will make $15 per share from the sale of the stock and keep the $1 premium. (55 Call Strike Price - $40 basis on stock = $15 gain on ICBM share).
The downside for Jane is that if ICBM shoots up to $70, she will miss out on the price increase beyond $55, the Strike Price of the ICBM call. In summary, the assumptions behind a Covered Call sale are:
1. The belief that the Stock will fall somewhat or stay the same. (If you think it will fall a lot, you should sell it!).
2. A willingness to sell the stock at the Strike Price of the Call or buy back the Call at a higher price than which you sold it.
Buying a Protective Put. This is a common protective strategy to protect a stockholder from fall in the stock price. If Jane holds ICBM and is concerned that it may fall, she has two choices. She can sell the stock outright right now or buy a Put. Jane still likes ICBM’s prospects for the long term. To protect herself from a short-term price declines, she decides to buy a Protective Put. ICBM is currently trading at $52 and Jane buys a Put with a Strike Price of $50. If ICBM falls to $50 or below, Jane can exercise her Put and sell ICBM for $50. She can also sell the Put at a profit.
MORE SPECULATIVE STRATEGY IN A FALLING MARKET
A popular strategy in
a falling market is to sell stocks and indexes short. Short selling is a little
complex and carries some measure of risk. Another strategy is to buy a Put on
the stock that you believe will fall in price.
You do not need to own the stock. It puts less capital at risk than
short selling. And it also give the investor leverage. Let’s look at an
example:
Jungle Jim does a lot of stock research. He believes that the stock of the American motorcycle behemoth, Hogsome-Darlington (HOG), will fall in price. It is currently trading at $49 per share. Jim thinks that the stock is only worth $40 per share. He also thinks that its next earnings report, to be issued in early January 2018, will be very disappointing and will send the stock falling. Instead of selling HOG stock short, he buys a February 2018 Put with a Strike Price of $55.00.
This Put costs him $3.00 per share, or $300 for the standardized 100 share options contract. Because the stock is trading at $50 and Jim’s Put has a Strike Price of $55, this Put is considered an “In the Money Put”. The Put is considered “In the Money” because the Strike Price is higher than the price of the HOG stock.
Jungle Jim does a lot of stock research. He believes that the stock of the American motorcycle behemoth, Hogsome-Darlington (HOG), will fall in price. It is currently trading at $49 per share. Jim thinks that the stock is only worth $40 per share. He also thinks that its next earnings report, to be issued in early January 2018, will be very disappointing and will send the stock falling. Instead of selling HOG stock short, he buys a February 2018 Put with a Strike Price of $55.00.
This Put costs him $3.00 per share, or $300 for the standardized 100 share options contract. Because the stock is trading at $50 and Jim’s Put has a Strike Price of $55, this Put is considered an “In the Money Put”. The Put is considered “In the Money” because the Strike Price is higher than the price of the HOG stock.
Options can be “In
the Money”, “At the Money” or “Out of the Money.” For an explanation of these
terms, take a look at the chart below:
STRIKE PRICE/HOG STOCK PRICE/PUT STATUS
$55 / $50 / Put In the Money by $5 – The Put at $55 give you the right to sell stock at $55 when the going price in the market is $50.
If Strike Price > Market, Put is in the Money (ITM)
$55 / $50 / In the Money by $5
$50 / $50 / At the Money (ATM)
Strike Price=Market Price
STRIKE PRICE/HOG STOCK PRICE/PUT STATUS
$55 / $50 / Put In the Money by $5 – The Put at $55 give you the right to sell stock at $55 when the going price in the market is $50.
If Strike Price > Market, Put is in the Money (ITM)
$55 / $50 / In the Money by $5
$50 / $50 / At the Money (ATM)
Strike Price=Market Price
$50 / $50 / At
the Money
$50 / $55 / Out of the Money by $5 ()TM)
If Market Price > Strike
Now let’s keep in mind that Jim does not own HOG stock. He is hoping that HOG will fall in price and the Put will rise in price beyond the $3 he paid for it. And Jim knows that as the Price of HOG falls, his Put will rise in price. Remember, a Put gives you the right to sell the stock at the Strike Price. So if Jim (or some HOG stockholder) has the right to sell HOG shares at $50 when the market price of HOG is at $40, he has a valuable right. And as HOG price falls, the value of the Put will rise.
$50 / $55 / Out of the Money by $5 ()TM)
If Market Price > Strike
Now let’s keep in mind that Jim does not own HOG stock. He is hoping that HOG will fall in price and the Put will rise in price beyond the $3 he paid for it. And Jim knows that as the Price of HOG falls, his Put will rise in price. Remember, a Put gives you the right to sell the stock at the Strike Price. So if Jim (or some HOG stockholder) has the right to sell HOG shares at $50 when the market price of HOG is at $40, he has a valuable right. And as HOG price falls, the value of the Put will rise.
Brokerage firms
require that customers execute options agreements to trade options and that
they understand the risks involved. In this last example, the risk of buying a
Put when you do not own the underlying stock is that the price of the stock
will rise instead of fall and that the put may expire worthless. The risk of
buying a put is less than short-selling the underlying stock, however. In this
case, Jim’s loss is capped at $300, the amount he spent on the Put. But if Jim sells
HOG short and HOG rises, he will have to buy 100 shared of HOG to cover. If HOG
makes a substantial move upward, Jim could lose thousands of dollars.
THERE ARE ALWAYS OPTIONS IN THE DESERT OF THE REAL!
[i] The Author has discussed the Secular Bear Market in several editions of the Newsletter and on the post of September 19th. http://desertoftherealecononomicanalysis.blogspot.com/2005_09_18_
desertoftherealecononomicanalysis_archive.html
[ii] http//desertoftherealecononomicanalysis.blogspot.com/2005_10_09_
desertoftherealecononomicanalysis_archive.html
[iii] http://www.cboe.com/. The website of the Chicago Board of Options Exchange has lots of information on all of these option topics, including Delta. The exchange will also send you a CD with Option information and tutorials.
THERE ARE ALWAYS OPTIONS IN THE DESERT OF THE REAL!
[i] The Author has discussed the Secular Bear Market in several editions of the Newsletter and on the post of September 19th. http://desertoftherealecononomicanalysis.blogspot.com/2005_09_18_
desertoftherealecononomicanalysis_archive.html
[ii] http//desertoftherealecononomicanalysis.blogspot.com/2005_10_09_
desertoftherealecononomicanalysis_archive.html
[iii] http://www.cboe.com/. The website of the Chicago Board of Options Exchange has lots of information on all of these option topics, including Delta. The exchange will also send you a CD with Option information and tutorials.
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