It’s Christmas and the traffic in the city is just scary, especially after lunch. I’m starting to suggest to friends to instead have breakfast parties rather than dinner parties to celebrate. It’s always nice to have options doesn’t it?! Or Skype parties… since the whole point of getting together is the conversation 🙂
How to stay relaxed this holiday season… it’s always nice to have options.
In the same vein, I am so delighted that there are Options for our financial investments. Options are basically contracts that you can use with your investments. Quickly, there are 2 types, Calls and Puts. Call options are used for making sure you have the right “to buy”, while Put Options give you the right “to sell”. Here are the benefits:
Earn income
You can earn income over and above dividends by writing call options against shares you own.
This is a very popular strategy with investors who expect the price of their shares to remain flat or fall slightly. Writing call options can generate extra income during such periods.
For example, assume you own 100 shares in Intel (INTC), which in early December are trading at $35. You believe that over the next couple of months, the share price is likely to stay around current levels.
You write a January expiry 35 Call option for a premium of $.80
Writing the January 35 Call means that you accept the obligation to sell your Intel shares for $35, if the option is exercised. For this you receive the premium of 80 cents per share ($80 for the contract).
If at expiry, the share price is below $35, the option should expire worthless. Your INTC shares may have fallen in value, but you have earned $80 in extra income for selling the call. Because of the extra income, in this example the share price can fall to $34.20 before you make a loss on the strategy overall.
If, however, the share price is above $35, the option will be exercised and you will have to sell your shares. Effectively you have sold your shares for $35.80 (the exercise price of $35 plus the option premium of $.80).
Brokerage and transaction fees will also apply when trading and exercising option contracts.
Protect the value of your shares
Put options allow you to protect your shares against a fall in value. Buying a put option locks in the sale price of your shares for the life of the option, no matter how low the share price may go.
Without using put options, in a market downturn you can only watch your shares fall in value, or sell them.
For example, if in early December you believe the share price of Visa is going to fall from current levels of $80, you could buy a V Dec 80 Put option, say for $1.80. This option gives you the right to sell your V shares at the exercise price of approximately $80 any time up until the option’s expiry.
A great advantage of this strategy is that if the share price should rise, you are not obligated to sell your shares. Your shares will benefit from the price rise, and all you have lost is the put option premium.
Speculate
You can use options to profit from a movement in the underlying shares without having to trade the shares themselves.
Options give you exposure to movements in the share price for a fraction of the cost of purchasing the shares themselves. Because of the small initial outlay, you can gain leveraged exposure to share price moves. For example, Warren Buffett’s company Berkshire Hathaway whose “A” shares are worth 204,945 would perform the same as “B” shares worth 136.43 which has a $137 call option costing only 50c.
With an increase in the price of the underlying shares, the percentage return on the purchase of a call option may be greater than on the purchase of the underlying stock. Similarly, if the price of the underlying shares fall, percentage return on the purchase of a put option may be greater than the percentage change in value of the shares.
However, just as leverage provides the potential to make high percentage returns, it also involves the risk of making large percentage losses. AS A BEGINNER, you will only be allowed the strategy with the limited risk, typically, you will only lose the premium you paid.
Time to decide
There may be times when you are unsure whether you want to go ahead with the purchase or sale of shares. Buying an option enables you to defer your decision until the option’s expiry.
When you buy a call option you lock in the purchase price for the shares. You then have until the expiry day to decide whether or not to exercise the option and buy the shares. Similarly, by taking a put option you lock in a selling price, and give yourself time to decide whether or not to proceed with the sale of the shares.
In both cases, the most you can lose is the premium you have paid for the option in the first place.
How Options are traded
Options are traded through stock brokerages ( which are then interconnected to the NYSE, NASDAQ
Opening and closing option positions are facilitated by the Market Makers operating in US options market. Market Makers play an important role in the options market, and are required under the Market Rules to provide quotes in certain option Series. Their obligations to provide quotes are not unqualified and your ability to trade out of a strategy may depend on if you are able to obtain a quote from a Market Maker.
This requirement is to promote liquidity in the market, so that you are more easily able to trade into and out of option positions.
In order to trade options, clients will have to open an options account with a broker, and sign a client agreement form and a risk disclosure statement.
A broker will provide you with these documents.
