In addition to buying and selling stocks and funds, you can also buy and sell “options”.
To understand what options are, I am going to define some terms and give some examples.
The person who sells the option is known as the “option writer” and he or she sells the option to an “option buyer“.
The option contract gives the buyer the right, but not the obligation, to buy (call option) or sell (put option) the underlying asset at an agreed-upon price (known as the “strike price“) during a certain period of time (“expiration date“).
A covered option means I own the stock that I am going to sell an option on. (If I don’t own the stock, its naked. Selling naked options is very risky).
Option contracts are sold in bundles of 100 shares of stocks. You can not sell an option of 99 shares, nor 101 shares. If you have 200 shares, you can sell 2 contracts.
The amount you pay for an option contract is known as the option premium. When you look at it option price, it is showing you the price per share. So, for example, if the option price is $.05, you have to then multiple that by 100, which means the the option premium is $5.
As the share price of a stock rises, the option price rises.
And, as the share price drops, the option price drops.
For example purposes, I own 100 shares of Acme Widgets, Inc. Let’s assume that Acme Widgets, Inc, is trading for $100 today.
I can sell someone the *right* to purchase 100 shares of Acme Widgets, Inc, anytime during the next 6-months (for example), for $115 a share. The buyer of the option pays me $1 per share, so I just collected $100 in option premium. If, tomorrow, Acme Widgets, Inc, shares are trading for $105 a share, the buyer could sell the option to someone else for say $1.10 a share. If, on the other hand, it is trading for $90 a share, the buyer may only be able to sell the option for $.90 a share.
When the option writer sells an option they are “selling to open” the option contract.
The option writer can purchase back the option. This is called “buying to close“.
Note that the Option Writer owns the shares. He or she, however, has sold the exclusive right to someone else to buy (or sell) the shares. Any dividends, for example, that are declared and paid out would go to the Option Writer in this example.
So, why do option buyers by options?
In my example about Acme Widgets, Inc, let’s say that instead of going to $115 a share, Acme Widgets, Inc, goes to $175 a share. The option buyer can buy it for $115 a share and then immediately sell it for $175 a share.
$115 * 100 = $11,500 purchase price.
$175 * 100 = $17,500 purchase price.
$1 *100 = $100 option premium.
Profit = $5,900.
So, why do option writers sell options?
It gets immediately liquidity into their accounts. Before I started selling options, I would buy a stock and then would immediately (in most cases) put the stock up for sale via a limit order for a 20-50% profit. I do the same thing now, except I do it via an option (covered call, in this case).
My basic strategy – I increase my monthly cash flow by selling covered calls against the stocks I own. I still own the stocks and collect dividends, etc, during the time the option is held. The option gives the option buyer the exclusive right, but not obligation, to purchase the underlying security at a preset price (the strike price) on or before the expiration date. They pay an option premium for this right, which, as the option seller, is mine to keep. If they execute the option they then pay the strike price, in addition to the option premium they already paid. Options can be purchased and sold. If you are selling the option originally, you are “selling to open”. You can always “buy to close” which will then close the option, allowing you to sell again. I strive to sell options on days the market is going up and buy back options on the days the market is going down.
I have started including net options premiums in my monthly dividend recaps.