I received an email the other day asking if I would cover options investing strategies so I figured that I would do that today. Options investing has increased in popularity over the past two decades and many investors are regular options investors. The most popular options investors are the Najarian brothers on CNBC’s Fast Money. They are helping to get regular investors involved in the options market.
What Are Call Options?
An option gives you the right to buy or sell shares of a of particular company. A call option gives you the right to buy a stock at a specified price. The price that the option can be exercised at is known as the strike price. It’s important to note that you do not have to exercise an option. You can simply let it expire. Options investing is a lot cheaper than stock investing because you don’t have to buy the shares of a stock.
Buying Call Options
One way that an investor can buy a stock cheaply is by purchasing a call option. A call option contract gives an investor the option to buy 100 shares of a stock. Buying call options makes sense if an investor expect a stock price to move higher over the next few months. If the stock price does move higher an investor can
- Exercise the option and buy 100 shares at the much lower price.
- Sell the options contract on the open market at a premium price.
Either way an investor would be making money. The only way that an investor can lose money buying call options is if the stock stays flat or goes down in price. An investor would lose the amount of money that you paid for the options contract.
Selling call options makes sense if an individual thinks that the price of a stock is going to fall. An individual would write a call options contract and sell it on the open market. The purchaser of the call option would pay a premium to buy the contract. If the stock price drops or stays the same, the contract writer could pocket the premium. If the stock price increases, the option would be exercised and the contract writer would need to deliver 100 shares for each contract.
There is a great deal of risk involved in writing naked calls. The risk is unlimited since a stock’s price could rise drastically forcing you to cover the position.
A covered call strategy is an options strategy where an investor initiates a long position in a stock and sells call options on that same stock. The contract writer would use this strategy to generate income while holding a stock. This strategy is very effective to use on stocks that the contract writer expects to either decrease in value or remain flat.
If the stock price stays the same, the call position will expire and the contract writer gets to keep the premium as a profit. If the stock price drops, they buyer won’t exercise the call option because they can buy shares cheaper on the open market. Again,the contract writer gets to pocket the premium.
If the stock price rises, the option would be exercised and the contract writer would have to deliver 100 share per contract. Since the contract writer already owns shares of the stock, the risk would be limited.
You should now have a better understanding of buying, selling call options and the risks involved with each.