It is usually better to be a seller of options than a buyer of options.
We don’t usually recommend the use of any options in our client’s accounts. Their potential uses are specific and limited. This week we will explain one of the safe forms of options: “Selling covered call options.”
First, I will use a real world example to explain what “selling a covered call option” is, and then I will explain the potential advantages.
On June 6th we sold an option for someone to buy our client’s 2,700 shares of Motorola stock for $10 per share until July 18, 2003. Motorola was trading around 8.70 that day. No one bought the actual shares of Motorola. They simply bought the right to purchase our 2,700 shares at $10 per share anytime between now and July 18, 2003.
In options lingo, they bought 27 “contracts” (each contract is worth 100 shares) at a “strike price” of $10.00. Different strike prices sell for different amounts. Strike prices far above the current price of the stock are very inexpensive. Contracts also expire at different dates. These contracts expired in July. Option contracts further in the future are generally worth more because the market has more time to reach the strike price. Options always expire on the 3rd Friday of the Month. Stocks can be very volatile right before the third Friday of the month because of expiring options.
We received 0.25 per share when we sold these contracts. We received $675 (less the trading expense) for a net gain of $598.
These options are worthless unless Motorola reaches 10.00 per share before the expiration date. That means unless Motorola had appreciated 15% in the next six weeks the buyer wasted their money. We received just over 2.5% of the current price of the stock for selling our options.
If Motorola had soared in value, we would have limited our upside potential to 17.5% in the next six weeks. We would have been paid 15% more for our stock (10.00) and we had already received 2.5% for selling the option.
On the other hand, if Motorola goes down 2.5% we would still break even because we had received the equivalent in value already.
If Motorola had fallen drastically in the next six weeks then we, and not the buyer of our option, would have been left holding a stock whose value is much reduced.
Another way of looking at it is that we would “win” if the stock growth is between positive 15% and negative 2.5% in the next six weeks.
The buyer of the option wins if the stock does better than +15% by calling the option and buying our stock for less than it is then worth. But we also win by covering our option with stock we already have and selling that stock for a 15% profit.
The only case we would lose is when the stock drops sharply and we have assumed the downside risk. The buyer of our option is then very glad to have only bought an option to buy the stock. Their option may be worthless, but it only cost 2.5% of the stock which has now lost an even higher percentage of its worth.
As it turns out in our case Motorola closed above 10.00 on July 7 and July 9, dropping back to 9.05 by the time the option expired. It never got far enough about 10.00 for the owner of the option to exercise it, purchase our stock and assume the downside risk. It is possible they sold the option for a higher price as Motorola appreciated to some other investor who then found the option to be worthless as the call date approach.
In any case, we made $598 and still own our now appreciated Motorola stock. We are still looking to diversify this position, and we can repeat the process until one of the options we sell is exercised and our stock is called.
Since stocks generally go up gradually, selling covered call options is a way of boosting returns for stock that you are willing to sell.
This technique should only be used if:
1. You think that the stock is stable or in an upward momentum
2. You have other reasons to sell the stock (such as diversification)
3. You might otherwise use a limit order to sell the stock
4. You own enough shares to justify the transaction costs of selling the option
5. The bid/ask price for the option justifies the transaction
Because options are not highly traded, it is important to look carefully at the bid and ask prices for various months and strike prices and potentially use a limit order for the option itself in order to get the best possible price.
Again, we usually don’t recommend the use of any options except in very specific and limited situations.
Photo by Jean-Philippe Delberghe on Unsplash