April 10th, 2013 | 13 Comments
Previously, in part 1 of our options primer we discussed what options are and why you might want to use them. Now it’s time that we move onto part 2, where we’ll focus on how to read an options listing and how to go about selling cash-secured puts and covered calls. We’ll also cover how to escape from an option that you no longer want and remind you once again of the risks of dabbling in options.
You may need an options approved brokerage account
Depending on your brokerage service, you made need to have your account approved for options. You simply fill out a small questionnaire about your investing experience, income, and liquid holdings. The objective is not to make your life miserable, but rather to protect you from risk – options can be very risky. Getting into the first tier of options trading (writing cash-secured puts and covered calls) is pretty easy. After you’ve written a couple of these style options, getting to the level of being able to purchase options is also pretty easy.
I do not recommend progressing any further down the path of options. Things can get a lot more complicated when margin comes into play, and you begin writing spreads and dealing with naked options. This is best left to professionals and speculators.
The options table
The following screenshot of an options table come from Google finance. It shows calls on the left side and puts on the right side. In the center is the strike price of the underlying security. Other companies will display the same information in very similar ways.
Note that the underlying security, Coca-cola (KO), is trading at $36.
How to read an options table, starting from the very top:
- The name of the underlying security. In this case, Coca-cola (KO).
- The expiration date of the option. As I’m certain that you recall, the expiration date is the date in which either the option contract is executed or the option expires worthless. In this case the expiration date is Aug 17th, 2013. Options expire on the 3rd Saturday of the month.
- Down the center is the strike price of the underlying security.
- Displayed on the left-hand side are call options, with put options displayed on the right-hand side. As you go from top to bottom of the table, the strike price increases.
- Each row represents a single call option and a single put option for the given strike price.
- On the far left of the call and put columns is a price column. The price represents the price of the options contract per share of the underlying security. Remember that each options contract controls 100 shares of the underlying stock. So if you sold one $3.00 put option, you would receive $300 ($3.00 x 100) as your premium.
- Notice how the price of call options decreases as the strike price increases, while the price of put options increases as the strike price increases.
- The highlighted options are all in the money. For calls, that means those options where the strike price is below the current price of the security. For puts, that means those options where the strike price is above the current price of the security.
The less important information:
- Change - How much the price of the option has changed today.
- Bid - The price that sellers are asking for the option.
- Ask - The price that buyers are asking for the option.
- Volume - The number of options contracts traded today.
- Open Int - The number of options contracts that exist.
Cash-Secured Puts - Sell to open
The act of initiating an option position is known as “opening” the position.
Now that we know how to read an options table, let’s write our first cash-secured put. Remember that KO is trading at $36 and if we are going to write a cash-secured put, we feel strongly that KO is going go up in price.
Based on the table, we decide to sell one August 17th, 2013 put with a strike price of $37.50. The option is selling for $3.00 per share, and thus we will pocket $300 from the sale of the option. The option sells at $3.00 per share and each options contract controls 100 shares of the underlying stock. So 3 x 100 = $300.
In order to sell this put, $3,750 of our cash will be locked down (secured) by the brokerage company. We cannot withdraw this money or use it buy securities. The money will, however, continue to bare interest. In case you were wondering, the money is being secured in case we are assigned KO. If that happens, we will receive 100 shares of KO in exchange for $3,750. Plus commissions, of course. If the option expires worthless, or we choose to close the position by buying back the option, our $3,750 will be freed up.
Note: You must have at least the strike price x 100 dollars in free cash to be able to write a cash-secured put.
Also note: You may be assigned the shares at any point while you hold the option if the price of the underlying security falls below the strike price.
Covered Calls - Sell to open
For completeness sake, let’s run the same example with a covered call. KO is still trading at $36, except this time instead of having $3,750 in cash laying around, we have 100 shares of KO.
Based on the table, we decide to sell one August 17th, 2013 call with a strike price of $35.00. The option is selling for $2.49 per share, and thus we will pocket $249 from the sale of the option. The option sells at $2.49 per share and each options contract controls 100 shares of the underlying stock. So 2.49 x 100 = $249.
If we sell this call, 100 shares of KO will be locked down. We will not be able to sell those shares while the option remains open. The shares will be able to appreciate or depreciate in price, and we will continue to receive dividends from KO as normal while the option is open. We just can’t sell them. The shares are being held in case the option expires in the money and we are forced to sell KO. In that case, we will receive $3,500 in exchange for our 100 shares. If the option expires worthless, or we choose to close the position by buying back the option, our 100 shares are freed up.
Note: You must own at least 100 shares of the underlying stock to write covered calls.
Also note: The underlying security may be called away at any time while you hold the option.
Buy to close – the option escape hatch
What if you want your money or stock freed up before the option expiration date? Or what if the price of the underlying security isn’t moving the way you expected and you want to get out of your option before assignment happens. Fortunately, there is an escape hatch.
Just as you sold an option to open a position, you can buy back the same option to close the position. You will have to buy the option back at whatever the current market price of the option is. Options lose value over time, but gain value with increased volatility and with changes in the strike price. Generally, puts go up as the strike price drops, while calls go up as the strike price rises.
If you can close out your option position for less money than you opened it, you made a profit! Good job. If you close out your position for more money than you opened it, you lost money – but at least you get to avoid assignment.
Know your risks
With cash-secured puts, you may be assigned the shares at any point while you hold the option if the price of the underlying security falls below the strike price. This is why I will only write puts against dividend growth stocks that I would like to own.
With covered calls, the underlying security may be called away at any time while you hold the option. Personally, I don’t like the idea of being forced to sell my stock, so I avoid writing covered calls. However, if there was a stock that I was hoping to get rid of, but not in a hurry to dispose of, I would write a covered call. In that scenario, I would consider the stock being called away to be a blessing in disguise.
Disclaimer: I am currently long KO. No plans to sell or buy any KO options.
Readers: Do you write options? Are you interested in starting? How concerned are you about the risks. How much of a potential return would you like to see in order to consider using options?
Written by myfijourney
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