By Randal Bailey
March 10th 2016
At Legacy Investment Group, LLC we grow our clients’ accounts primarily by selling options. The question we are asked the most is… “How can I sell something if I don’t own it?” This can be difficult for people to understand because most of you only know how to make money in the stock market one way – buying low and selling higher. The stock market, according to data based on calendar year returns of the TSX from 1920 – 2010, has gone up 73.9% of the time. That doesn’t mean that buying and holding will guarantee that you will make money. People tend to make buying and selling decisions emotionally and not logically. That means you buy near market tops because everyone else is making money and you haven’t bought in yet then you sell near bottoms because after losing money from your initial purchase you get more and more scared as the market continues to decline until you can’t take it anymore and sell.
An option contract can be bought or sold to “open” a position and to close an open position you would do the opposite action of opening or let the contract expire. For example; I sell to open a positon. I can then buy to close it or wait till the expiration date and let it expire or be obligated to fulfill the contract. I buy to open a position. I can sell to close it or wait till the expiration date and let the contract expire or have the right to enforce the contract. The important thing to know is that buyers have rights and sellers have obligations. When we sell a put option the buyer has the right to sell us the optioned stock at the strike price on the contract and we are obligated to buy their stock at that price.
Think of the buyer as looking to “insure” their stocks from going down by buying the ability to sell them at a specific price in the future. Think of the seller (Legacy Investment Groups’ clients) as the insurance company collecting the premium and being willing to “pay the claim” (buy the stock) if the price of the stock drops below the strike price.
All options have a specific time frame and a previously agreed upon strike price. I like to think of the strike price as the price both parties were willing to “strike” a deal at. When we sell a put option, we have to keep the cash that would be needed to “pay the claim” reserved until the contact expiration date.
One contract covers 100 shares of the optioned stock, if the strike price was $100.00 dollars; we would have to reserve $10,000 dollars in our money market until the contract expires. The reason we like to sell put options for our clients is because 73.9% of the time the market goes up and according to CME data, 76.5% of all options held to expiration expire worthless. We love to collect the premium and let our sold options expire worthless!
The best thing about this conservative strategy is that if we sell a put option with a strike price below the current price of the optioned stock we can make money four ways; we win if the stock goes up a lot, goes up a little, goes nowhere and even if it goes down a little. The option will expire worthless as long as the strike price is below the price at expiration.
How Options Work By Forbes
Options are the most versatile trading instrument ever invented. Since options cost less than stock, they provide a high leverage approach to trading that can significantly limit the overall risk of a trade or provide additional income. Simply put, option buyers have rights and option sellers have obligations. Option buyers have the right, but not the obligation, to buy (call) or sell (put) the underlying stock (or futures contract) at a specified price until the 3rd Friday of their expiration month. There are two kinds of options: calls and puts. Call options give you the right to buy the underlying asset. Put options give you the right to sell the underlying asset. It is essential to become familiar with the inner workings of both. Every strategy you learn from this point on depends on your thorough understanding of these two kinds of options.
There are no margin requirements if you want to purchase an option because your risk is limited to the price of the option. In contrast, option sellers receive a credit in their account for selling an option and get to keep this amount if the option expires worthless. However, option sellers also have an obligation to buy (put) or sell (call) the underlying instrument if their option is exercised by an assigned option holder. Therefore, selling an option requires a healthy margin.
To trade options, you must be acquainted with the select terminology of the option market. The price at which an underlying stock can be purchased or sold if the option is exercised is called the strike price. Options are available in several strike prices above and below the current price of the underlying asset. Stocks priced below $25 per share usually have strike prices at 2 dollar intervals. Stocks priced over $25 usually have strike prices at $5 dollar intervals.
The date the option expires is referred to as the expiration date. A stock option expires by close of business on the 3rd Friday of the expiration month. All listed options have options available for the current month and the next month as well as specific future months. Each stock has a corresponding cycle of months that they offer options in. There are three fixed expiration cycles available. Each cycle has a four-month interval:
- January, April, July and October
- February, May, August and November
- March, June, September and December
The price of an option is called the premium. An option’s premium is determined by a number of factors including the current price of the underlying asset, the strike price of the option, the time remaining until expiration, and volatility. An option premium is priced on a per share basis. Each option on a stock corresponds to 100 shares. Therefore, if the premium of an option is priced at 2, the total premium for that option would be $200 (2 x 100 = $200). Buying an option creates a debit in the amount of the premium to the buyer’s trading account. Selling an option creates a credit in the amount of the premium to the seller’s trading account:
|Example: Jane wants to buy a house. After a few weeks of searching, she discovers one she really likes. Unfortunately, she won’t have enough money for a substantial down payment for another six months. So, she approaches the owner of the house and negotiates an option to buy the house within 6 months for $100,000. The owner agrees to sell her the option for $2,000.Scenario 1: During this 6-month period, Jane discovers an oil field underneath the property. The value of the house shoots up to $1,000,000. However, the writer of the option (the owner) is obligated to sell the house to Jane for $100,000. Jane buys the house for a total cost of $102,000-$100,000 for the house plus the $2,000 premium paid for the option. She promptly turns around and sells it for a million dollars for huge profit of $898,000 and lives happily ever after.
Scenario 2: Jane discovers a toxic waste dump on the property. Now the value of the house drops to zero and she obviously decides not to exercise the option to buy the house. In this case, Jane loses the $2,000 premium paid for the option to the owner of the property.
How Options Work Review
- Options give you the right to buy or sell an underlying instrument.
- If you buy an option, you are not obligated to buy or sell the underlying instrument; you simply have the right to.
- If you sell an option and the option is exercised, you are obligated to deliver the underlying asset (call) or take delivery of the underlying asset (put) at the strike price of the option regardless of the current price of the underlying asset.
- Options are good for a specified period of time, after which they expire and you lose your right to buy or sell the underlying instrument at the specified price.
- Options when bought are done so at a debit to the buyer.
- Options when sold are done so by giving a credit to the seller.
- Options are available in several strike prices representing the price of the underlying instrument.
- The cost of an option is referred to as the option premium. The price reflects a variety of factors including the current price of the underlying asset, the strike price of the option, the time remaining until expiration, and volatility.
- Options are not available on every stock. There are approximately 2,200 stocks with tradable options. Each stock option represents 100 shares of a company’s stock.
Original Article Sourced From;http://www.forbes.com/2006/10/18/markets-options_education_center_basic_how_options_work.html