Some Interesting Ways to Use Options

If you don't know much about stock options, wait until you read this! Most investors think that the only way to profit from investing is when the price increases (long position) or when price decreases (short position). However; with stock options, an investor can make money when there is no or little movement in a stock market or individual stock price. Consider the simple strategy of writing a covered call. (The term "covered" means that you own the underlying stock of the derivative stock option).

Writing an out-of-the-money call option

One of the many inviting strategies that can be used when there is little price movement in an underlying stock is to "pledge" the rights of your ownership to others. Some investors in the vast universe of stock option investors might believe that the stock you own may experience an increase in price within a certain time period. In order to position themselves to take advantage of their analysis, they look to purchase a call option(s) contract on the stock.

An option contract is composed of the temporary ownership of the rights to an underlying stock issue. To do this, they pay a premium for each share of stock. For example, a call option for a certain month may cost $2. This means that to borrow the rights for the underlying stock, an investor will pay $2 per share for 100 shares per contract; one contract would cost $200 plus transaction costs. If a stock has a current price of $32, 100 shares would cost about $3200 to purchase. On the other hand, to have the rights for 100 shares of the same stock would cost only $200 for a specific period of time. The cost of the premium depends upon if the option is in- the-money (ITM), out-of-the-money (OTM) and length of time left on the option. Of course, demand for the option is the major determinant.

The owner of a stock can "write" an out-of-the-money covered call whereby he/she pledges the rights to the stock in exchange of a premium payment. In the example above, the owner of the stock would receive the $200 premium for the rights to 100 shares if the stock for the specified time period. If the stock moves from OTM to ITM, the holder of the option may call away the stock and the writer of the call option must pass ownership of the stock to the option holder for the current market price of the stock. However, if the stock option does not move into-the-money, the option can't be exercised; the premium and the stock stay with the call option writer.

Covered call writers can repeat the process many times over with the same stock and still maintain. For example, if the owner of the stock had paid $3000 for 100 shares of XYZ and then writes 3 covered call contracts per year at the same premium price of $2 per share, the writer of the call options would realize an annual return of 20% including any appreciation which didn't trigger a call away of the underlying stock. However, the risk of writing covered calls is that if the stock appreciates and the underlying stock is called away, the owner would then lose the opportunity of taking advantage of the underlying stock appreciation.

Writing an in-the-money call

Here is another interesting way to take advantage of the tremendous flexibility of stock options. Instead of paying a broker to sell a stock position, why not make a profit by writing an in-the-money call.

Example:

Suppose the owner of 500 shares of Home Depot (HD) wants to sell the shares... Instead of calling his/her broker and telling the broker to sell the shares, the owner can write an in-the-money call. Keep in mind that ITM calls have higher premiums because of intrinsic and time value.

The owner of the shares discovers that an in-the-money call of the stock costs a premium of $9 per share for an HD-EG-E (May contract month with a strike price of $ 35, which is in the money because the current price of HD is $39.25). For the five contracts (500 shares), the owner would get a premium of $4500 less commissions for writing ITM options for the 500 shares he/she owns. The stock price is currently $39.25 and the calls will probably be exercised and the 500 shares will have to be assigned for the strike price of $35, and, therefore, the owner will lose $4.25 per share ($39.25-$35) for a loss of $2125. But the difference between the premiums ($4500) for the ITM covered calls and the projected loss of $2125 still gives the owner a net profit of $2375 and would give the owner a 12.1% return just on the sale of the underlying stock instead of selling at the current market price of $39.25 and paying commissions to sell the stock. What makes this covered call attractive is the time value of the option.

$ 35 Strike Price

$ 39.25 Current Price

Premium $ 9

Intrinsic Value

$ 4.25

Time Value

$ 4.75