How Investors Can Become Options Traders
If you invest in the stock market, you can use options trading to hedge your portfolio and generate additional income.
Many investors fear trading options because of the risks involved. And it is never recommended to use options without deeply understanding what you are investing in.
But if you understand what you are doing, option strategies can help reduce your risk or earn some extra money from your long-term stock portfolio.
Options Trading Terminology
If you want to implement options trading in your investment portfolio, you should know at least the basics of options trading terminology.
The most important terms you should know are the following:
Strike price
The strike is the price where the buyer can exercise a put or call option. This is the price you will get to buy (or sell) shares of stock upon the options expiration date.
Call option
A call option gives the buyer the right (but not the obligation) to purchase 100 shares of stock at the strike price.
Put option
A put option gives the buyer the right (but not the obligation) to sell 100 shares of stock at the strike price.
Premium
The premium of an option contract is the price the buyer must pay now to buy the option.
Covered call
A covered call is an options income trading strategy where you own 100 shares and write a call option to collect a premium from a buyer in exchange for accepting the obligation to sell your 100 shares at the expiration date and strike price.
Cash secured put
A cash secured put is an options income trading strategy where you write a put to collect a premium in exchange for the obligation to purchase 100 shares of stock at the expiration date and strike price.
Protective put
A protective put is an options strategy when you own 100 shares of a stock and buy a put to limit your overall downside risk.
Covered put
A covered put is when you are short 100 shares of stock and sell a put. It is the bearish version of a covered call.
Options Trading for Investors
Options trading terminology is confusing initially, but utilizing options income strategies like covered calls and cash secured puts are relatively straightforward.
All you need to start is 100 shares of a stock and a price at which you would be comfortable selling the shares. Of course, many investors already own shares, so selling covered calls for income is a great strategy to begin trading options for investors.
Additionally, investors can purchase shares of stock utilizing an options income strategy called cash-secured puts. Instead of just purchasing shares outright, you can sell a cash-secured put and agree to buy the shares at a discount.
Covered Calls
Let’s go over a basic example to understand how covered calls work. Let’s say you own 100 shares of stock XYZ at $50 per share, and it is trading at $55 per share.
Stock XYZ price per share: $55
Your cost basis: $50
Let’s say you are still bullish on the stock, but you are comfortable selling the stock at $65 per share. You can promise to sell your shares at $65 per share and get paid a premium if you sell a $65 strike call option. For this example, let’s say you collect $50 in premium for selling this covered call.
Two scenarios can play out with this covered call trade:
1- The stock stays below $65 per share by expiration, and you keep the $50 premium and your shares.
2- The stock goes over $65 per share on the expiration date, and you must sell them at $65 and still collect your premium of $50.
In both cases, you are making money. However, the risk of covered calls is missing out on a sizeable upward movement. If the stock rallies way above your strike price, you still have to sell at the lower price, and you will see an unrealized loss on the call option. This unrealized loss will disappear once the shares automatically get called out of your account.
The other risk of selling covered calls for income is experiencing losses from the shares. For example, if the stock drops from $65 to $30, you will still make the premium but lose much more on the shares. Additionally, it will be almost impossible to sell a call above your cost basis since it fell so low.
Cash-Secured Puts
Another fantastic options income strategy investors can use is the cash-secured put. Let’s review an example of a cash-secured put to simplify the strategy. If stock XYZ is trading at $50 per share and you are bullish, you can sell a cash-secured put.
Depending on the expiration date, you can sell a $40 strike put and collect around $50 in premium. When you sell a $40 strike put, you get paid to promise to purchase 100 shares at $40 per share.
Two scenarios can play out with this cash-secured put trade:
1- Stock XYZ stays above the $40 strike price, and you keep all the $50 in premium and are not obligated to purchase the shares.
2- Stock XYZ drops below $40 per share, and you are obligated to purchase 100 shares at the $40 strike price and keep the $50 in premium as cash in your account.
Regardless of the scenario, you are never taking more risk than buying 100 shares of stock outright. Additionally, you are collecting a premium which helps reduce your cost basis.
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As Always: Buy things that pay you to own them.
-Josh
Blog Post: #046
