Welcome to OptionChronicle.com’s Options Basics II
Selling Stock Options
In our Options Basics I article, we talked about the two kinds of options -- calls and puts -- and when it was best to use them. We also let you in on how options were priced and how they can be great tools for managing risk.
We're now going to dig a little deeper into making money with options. But this time we are going focus on the sell side of option trading. So let's get started!
When you buy a call or put, have you thought about the other side of the trade? In other words, have you considered whom you are buying a call or put from? Well, these people are called option sellers. And that makes perfect sense: After all, they've sold you the option! Option sellers are also called option writers. But before we get into how option sellers can make a ton of money, let's go back in history...
In the old days, one of this country's main sources of revenues was from the tobacco farming industry. But just as soon as tobacco farmers popped up, they quickly discovered the business they were in was very, very risky.
Every year when they planted their crop they would spend their life's savings on the crop. And they would do that without knowing with any certainty what prices their tobacco would draw in the open market. If fact, many worried if their crops would make it to market at all! Droughts, flooding and just about any agriculture malady loomed large over the early American tobacco farmer.
Talk about risk!
In fact, the tobacco farmer's risk was so big, everyone realized that if this country was going to move forward, they had to figure out a way to reduce that risk. If they didn't, farmers would hightail it for the exits. And that's one of the last things a growing country wanted.
In come the speculators. These forward thinking financiers were willing to offload some of the farmers' risk by agreeing to by the farmers' tobacco at a fixed price on an agreed upon future date. The farmer was better off because he was assured of a fixed price for this crop. And the speculator was better off because if the price of tobacco rose above what he agreed to pay the farmer for it, he would make a handsome profit.
In other words, the modern option market was created!
But it wasn't until the 1970's when options on stocks became available that the option market really took off.
Like the farmers before them, these stock option investors were often loaded down with tons of stock. And just like the farmers, that translated into tons of downside risk. In fact, they were under so much risk they would be willing to fix a price for their stock so long as they were assured of willing buyer.
In other words, they were willing to sell the right to buy their stock at a fixed price up until a fixed date. And in exchange for that right, the option buyer was required to pay a small fee.
Now, here's the best part. Once the option seller has received his fee, he gets to keep it. And that's true if his stock goes up or down!
Is this a big deal? Sure it is. Just like the early American tobacco farmer, the options market gives the modern stock owner a place to offload risk by agreeing to deliver stock for a fixed price. In the meantime, the option buyer gets a chance to make a tidy profit if prices go in his direction.
Let's look at an example...
Suppose you own 1,000 shares of ABC Inc. You bought this stock for $50.00 a share. Things have worked out nicely for ABC and the stock is now trading at $75.00 a share.
Now, you're not certain how much upside price movement is left in the stock. But you are certain you don't want to lose your gains. So, here's what you do:
You go to the options market and sell 10 ABC call options with a strike price of $80 and an expiration date in 60 days. Since each option contract is worth 100 shares, you've sold the right to buy all of your 1,000 ABC shares at a fixed price of $80 a share for a maximum of two months.
In exchange for that fixed price, the person you sold the option to pays you a fee -- called a premium -- of $5 per share. At 1,000 shares, you just banked a handsome $5,000. And that's yours to keep, no matter what happens to ABC stock.
Now, in 60 days if ABC stock is trading above $80, your option buyer will give you $80,000 -- called exercising his option -- and you'll give him 1,000 shares of ABC.
You make out like a bandit: You received $80 for a stock that you paid $50 a share for. That's a $30 gain per share. Plus, you get to keep the $5 a share you got for selling the option. All told, that's a $35 profit. Nice!
What happens if ABC doesn't go above $80? You get to keep the premium of $5 you already received and your stock to boot.
It gets better. You can repeat this process every month. And that means you can earn a nice bit of income without doing much at all!
Sure, you run the risk of having to sell ABC at a fixed price for a fixed amount of time. But if you like that fixed price, having to sell ABC would be just fine.
To sum up: The modern options market really hasn't changed that much from its humble beginnings. Like the farmers of old, modern stock owners are willing to fix a sales price for their stock -- in exchange for a fee -- so that can protect their downside. These option sellers can make a nice sum and, best of all, repeat the process for as long as their own their stock.
Hallaman Market Research
