Now, let's consider stock and stock options for a moment. Consider the ubiquitous XYZ Corp., currently trading at $95 per share on 2/1/03. If you pay $4 per share for a March call on 100 shares of XYZ at the $100 strike price, you have acquired the right to buy 100 shares of XYZ for $100 per share, any time before the third Friday in March. This cost you $400, plus commissions.
If XYZ is investigated for "irregular accounting practices" (the equivalent of discovering a toxic waste spill in the backyard), the share price may drop to $50. The call you paid $400 for is probably worth about $20. You've lost nearly 100% of your investment, and I wouldn't count on getting it back. But you've only lost $400.
Imagine if you had owned 100 shares of XYZ stock. What was worth $9500 yesterday is now worth $5000. That's a loss of $4500! Sure, you can wait for the stock to recover -- there's no time limit with stock.
The call, on the other hand, will expire worthless (or you'll sell it for next to nothing) in a few weeks, but would you rather lose $400 or $4500? Would you prefer to hang on for years, waiting for XYZ to double in price so you can break even, or would you rather accept your $400 loss and move on to the next opportunity?
On the other hand, suppose XYZ announces that they're coming out with the world's first odorless, tasteless, wireless, weightless, invisible widget (the diamond mine in the rose garden). The stock jumps to $150. Now your call is worth about $6500. Not bad for a $400 risk.
Imagine if you had owned 100 shares of XYZ stock. What was worth $9500 yesterday is now worth $15,000. Awesome. But look at the percentages. The stock increased 58%. Incredible. A gain of $5500. But the call increased a whopping 1525%. A gain of $6100. Of course, these numbers are fictitious, unrealistic, and tailored to make a point.
Stocks don't usually move like that. People rarely discover toxic dumps or diamond mines. But the point is that options move with the underlying, while costing you less and having a fixed, limited risk. Time is the one factor that is against you with options. It is the one gotcha you have to watch out for when buying options.
Selling Options
Now, let's look at the same events from the seller's viewpoint. First, let's suppose that the seller of the XYZ call also owns 100 shares of XYZ stock. This is known as a covered call. It is considered a conservative options position. Many IRA accounts that will not even let you buy a call or put will still let you sell a covered call against stock you own.
So, our call seller owns 100 shares of XYZ and sells a call against it. The irregular accounting practices investigation is announced and the stock plummets. The seller is stuck holding a stock that just lost nearly half its value. The one consolation is that the call premium, the $400 received for selling the call, is his to keep. Very little consolation, actually.
Holding stock has inherent risks, as the last few years has made abundantly clear. Selling the call put cash in his pocket, independent of the risk of holding the stock. In fact, had he held the stock, and not sold the covered call, he would have been $400 worse off.
Given the same 100 shares of stock and one short (meaning he sold) call, let's examine the diamond mine scenario. Here the stock shoots up over 50%. This is the part that makes call sellers very sad indeed. Instead of having a 50% increase in his stock, he has the $400 premium.
The call buyer is surely going to exercise his option to call the stock away from him at the strike price. That is, the call seller will have to sell his stock for $100, since that's what the strike price of the call is, even though the stock is now worth $150. He sold, for $400, his right to enjoy that big move.
But that is an emotional loss, not a financial one. He still sold his stock at the anticipated price, and pocketed the $400 option premium, as well. The fact that the stock climbed above his strike price is disappointing, but not a loss of money.
Sometimes the stock goes up just a little, or hovers near the strike price. If the stock goes up to $102, the call seller sells a $102 stock at the $100 strike price, but has still pocketed $4 per share on the call, and still ends up ahead. If the stock is at or below $100 on expiration day, the short call expires worthless, and the call writer has both the stock AND the $400 option premium. He can then write another call against the stock.
Naked Options
Now let's look briefly at the result of selling naked calls. In this scenario, the call writer simply sells the call and does not own any of the underlying stock to cover the short call. If the stock plummets, the call writer is very happy and relieved.
The premium of $400 is his to keep, and no one will be knocking on his door asking to buy the stock for $100 per share, since it is available on the open market for $50. It's his ideal scenario. Actually, any stock price at or below the strike price will be in his favor.
However, here's a very bad scenario. The call writer sells short a naked call. And the stock leaps 50%. He's got big problems. Somebody's going to want to buy XYZ from him for $100 per share, just as the option contract states.
But he doesn't own any shares of XYZ. So he now has to go to the open market and buy 100 shares at the current market price, which is $150 per share. He took in $400 of premium and now has to cover is with a $15,000 stock purchase, for which he will only receive $10,000. He loses $4600 ($10,000 - $15,000 + $400). Not a happy ending.
Do NOT even consider selling naked calls. Your broker probably would not allow you to anyway. However, until you really know what you are doing, don't sell naked puts either. When the bottom drops out of a market, naked put holders get very, very badly hurt. They are forced to pay high prices for low priced stock. You do NOT want to be in this position!
An option gives you something called leverage. Leverage is when you are able to control a large amount of money with a small investment. Each option contract lets you control 100 shares of stock for far less than the cost of buying those shares. But leverage is not the best reason to trade with options.
True, with the leverage that options afford you, you stand to risk less and make more, assuming things move in your favor AND in your time frame. Remember the expiration date! You have traded leverage for limited shelf life. If things don't move your way soon enough, you lose. So, what is the main reason to trade options? Spreads!
Article Source: http://www.orbitaloc.com/
Martin Chandra is a full-time investor. Get limited offers at here.
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