As year’s end approaches with what seems a cascade of bad economic news and forecasts of even worse to come in 2009, here’s a timely idea: Give yourself a holiday present.
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Hey Guys,
This is a GREAT SIMPLE article on options. Beyond the advice that it has is a great simple explanation of what the different types of options are.
I encourage you to read this before you dive into serious “options” trading.
Hope this helps!
d
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In a sense your fellow investors have already bestowed it. Their recent panicky buying and selling and their extreme risk aversion has driven market volatility to unheard-of levels. The standard measure of this, the VIX, hit an all-time high this fall. This, in turn, has driven prices on stock options to extremes that are beyond anything in my memory. At these prices I can’t imagine being a buyer. But for sellers, it’s quite an opportunity. You can sell an option and pocket the cash.
Every time I mention options, some investors panic at the thought that they’re too risky and complicated. Options strategies can be complex. But I don’t do anything that requires a computer program or a Ph.D. in math. Call options give you the right to buy shares; put options the right to sell. So selling a call gives someone else the right to buy from you at the strike price; selling a put obligates you to buy at the strike price. As a conservative investor I only sell calls on shares I own (a strategy known as selling “covered” calls). But selling puts doesn’t require owning shares, since your loss is capped at the strike price minus the proceeds of the sale, should you be required to buy when the stock is worthless. (For more on options basics check out the Chicago Board Options Exchange’s Learning Center.)
Until the stars recently aligned in this highly unusual market, I’ve rarely bothered to sell puts. I did once, hoping to buy the stock at the strike price when the put expired, which was a discount to the price when I bought the option. (This is known as an “in the money” put.) Instead the stock price rose far above the strike price. I kept the rather modest proceeds from selling the put, which was all profit, but didn’t get the stock. Despite this favorable outcome, I felt vaguely disgruntled, disappointed I didn’t get to buy the stock at a discount.
So I’m no longer selling puts as an acquisition strategy. But with the prices of options so high, my interest in selling has been renewed. What’s so bad about a tidy sum of cash, even if I don’t get the stock?
I’ve had much better luck selling calls, as I’ve often reported. If the stock price doesn’t reach the strike price, you just keep the cash and the shares, as I have on numerous occasions.
Of course, in both cases there are risks, as there are in any options strategy. If you sell calls, and the stock price soars, you will have foregone an unlimited amount of gain. (That’s never happened to me, but in this environment it pays to remember that anything can happen.) With puts, the stock price can fall to zero, but you’re still obligated to buy at the strike price. Broadly speaking, you usually sell puts when you think the market will rise, calls when you expect it to fall. Both scenarios leave you with the cash you realized from the option sale.
With stock prices as depressed as they’ve been recently, this past week I focused on selling puts. (If you’re still bearish, consider selling calls.) I zeroed in on financial stocks, both because they’ve been battered and because I’ve gradually been adding to my holdings in the sector, and thus wouldn’t mind buying the shares if prices fall further and any puts I sold expire in the money. Essentially, I’m selling skittish investors an insurance policy: If things get even worse, I’ll buy their shares at the strike price.
Right now, those investors are paying a great deal for that peace of mind. What did I find? Premiums so rich I consulted a colleague to make sure they were real.
Among a bevy of alternatives, I sold puts on J.P. Morgan Chase (JPM: 32.47*, +3.84, +13.41%), Wells Fargo (WFC: 29.78*, +3.71, +14.23%) and, a bit further out on the risk curve, Morgan Stanley (MS: 16.22*, +2.58, +18.91%). I sold $25 J.P. Morgan puts for $8.45 and $10 Morgan Stanley puts for $3.40, both expiring in January 2010, and $27.50 Wells Fargo puts for $9.20, expiring January 2011. (You can also sell much shorter-term options, though the premiums are generally lower.) The cash is now in my account, and it’s more than enough to pay for all my Christmas shopping.
Not that I recommend rushing out to spend it, welcome though such a consumer stimulus might be. The proceeds are carried as a debt on my account statement, which is a useful reminder that selling an option is a liability. For example, if Wells Fargo is below $18.30 a share when the option expires — $27.50 strike price minus the $9.20 premium — I’ll have to buy the stock at a loss. Only when I close out the position or the options expire will I know for sure if the strategy paid off.
I only recommend this for investors comfortable with a degree of risk. But from my point of view, this is a rare opportunity to make money instead of complaining how bad everything is.