Many investors, when they hear the word “options,” immediately think, “gambling.” That’s not a bad guess, either. Typically, when somebody touts options, the pitch is for you to buy these instruments in order to speculate on the movement of a stock or commodity. With a small stake in options, the tease goes, you can multiply your money 100%, 200% and more if the market swings in your direction. Furthermore, your risk is “strictly limited” if you happen to be wrong.
All true enough. However, there are some caveats. The most important: Options have a fixed life. If you pay $1 for a call option that entitles you to buy 100 shares of “XYZ” stock at $20 within the next three months, and “XYZ” never goes above $20 during that period, your call will expire and become worthless. Yes, your risk is limited — to a 100% loss!
It’s this time decay in the value of an option that causes most options buyers to lose money over the long run. As in a gambling casino, the odds are stacked in favor of the house. The longer you play, the more likely you’ll end up a loser.
Ah, but what if you could change seats and assume the role of the house yourself? Actually, you can — by selling or (in the parlance of the trade) “writing” options. Writing options isn’t a one-way ticket to riches, but if conducted properly, it can add to your overall portfolio returns while shaving your risk.
The best place to begin is by selling calls against stocks you already own. Known as “covered” call writing, this technique lets you collect a premium for giving the option buyer the right to purchase your stock at a specified price until a certain date.
In the example I gave you earlier, “XYZ” shares may be trading around $19. Calls that can be exercised at $20 per share for three months may be quoted around $1. You sell one call, representing the 100 shares of “XYZ” you already own.
If, by expiration date, “XYZ” has never traded above $20, you’ll be able to keep the $100 premium (less brokerage commission). On the other hand, if “XYZ” climbs above $20, chances are the buyer will “call” your stock away, paying $20 per share for it. In effect, you’ll have sold your stock for $21 (less commissions).
As you probably can see if you’ve followed me this far, the key is to set the exercise price (also known as the strike price) of the option far enough above the current price of the stock to prevent your shares from being called away, yet low enough to earn a reasonable premium for the option.
How do you achieve this balancing act? Here are two guidelines: