If you are not an experienced investor, initially you will only be granted permission by your online brokerage account to write covered calls and maybe sell put options. I think you’ll find those two option strategies more than enough to add to your investing toolbox. You have to request permission to trade options by sending in paperwork or completing a simple online form.
Here’s how covered calls work: Let's say you bought 100 shares of Nike at $70 per share, and now the stock is trading at $74 per share. You have a $400 unrealized gain. According to the option chain (a table of dynamic option prices available on your online broker’s website), which I checked at some point on January 31, if you agreed to sell your 100 shares at $75 per share anytime between now and April 19 by selling a call option, your account would have been credited with $245 immediately. That's the premium you would earn for accepting the obligation to sell your shares if the buyer of the call option exercises her right. Options generally expire on the third Friday of every month, and I selected the April 19 expiration date as an example.
If Nike trades at or above $75 per share at expiration, you would be obligated to sell your shares at $75 per share and keep the $245. In that case, you make a $745 realized gain ($500 plus $245). If the stock trades below $75 at expiration, you will keep your shares at whatever price they are trading as well as the $245. This is because the buyer of the call option has no reason to pay $75 for stock she can acquire in the marketplace at a lower price. In either case, the $245 is yours to keep.
Why is this strategy less risky than simply purchasing Nike at the market price? Should the price of the stock fall below your purchase price of $70, selling the call option ends up being more profitable than just holding the stock because the $245 in premium you received in income offsets some of the loss in the stock price. In fact, you could even come out profitable if the stock fell to around $38 per share.
What’s the catch? You are placing a cap on the gain you can make on appreciation of the stock in exchange for predictable and immediate income. This is the tradeoff you make when writing covered calls. However, how many times do all your stock picks go up steadily each and every month? If you are that good of a stock picker, please give me a call!
Be aware that some option strategies such as selling a call option by itself (without owning the underlying shares of stock) carry unlimited risk. I have never sold a “naked” call, and I discourage the practice. When you sell a naked call, you only profit if a stock’s share price stays below a certain price. If the stock continues to rise in price, you can end up in a lot of trouble.
Laurie Itkin is the founder of The Options Lady and a financial advisor with Coastwise Capital Group. To order a copy of her book “Every Woman Should Know Her Options: Invest Your Way to Financial Empowerment,” go to www.theoptionslady.com.