Options Trading: A Recipe Book with Ingredients PART 3

What Are the Options Flavors?

One of the problems with some options training I have seen and books I have read is that the focus is often on too many things at the same time. Most books about trading options want to be comprehensive in explaining all the different types of options. When the novice is just starting to show an interest in the topic, I too am tempted to tell you about the different ways I use covered calls, cash covered puts, and option rolls. Those are just a few of the recipes in the options cookbook. But I think that may make it harder for you to learn the things you need to get started and have success. So we will start with a focus on call options. By using covered calls you really have little undefined risk.

Let’s review the options contract recipe: The four main ingredients for an option trade are ticker symbol, the share price, the date, and the profit you would like to get. You must have 100 shares to trade a single options contract. Options always expire on a Friday, with rare exceptions due to holidays. There are some stocks and ETFs that have weekly options, but most are monthly.

What are Call Options?

Both call options and put options are contracts. The easiest type of option to understand is the call option, so we will start with calls. The call option is an option that the buyer can call or demand that you sell your shares to them if the contract terms are met.

Many people equate options with renting an apartment. When I sell a covered call contract, the buyer of my contract pays me rent for my stock “building.” They don’t own the shares, but they may have “an option to buy” before the contract expires. However, they can’t or won’t buy at a price below the contract price 99.99% of the time. If they do this, they are paying you more than the shares are worth. The only time this might happen is if there is an Ex-Dividend date in the near future. I will discuss this more in a future post.

You set the terms of the contract and when the buyer buys your contract, they agree with the contract terms. This is automated. I never really talk to the buyer of my call contract. But I don’t sell call options on all of my stocks and ETFs. What are my choices? I can sell or rent my shares.

What Can I Do With My Shares?

Let’s pretend I own 100 shares of the “XYZ” company. Therefore, I have at least four choices. (Note: A kind reader informed me that I have an error in this table. Therefore, on 09/16/23 I corrected the text in this post but did not update the table. The illustration below is for 1,000 shares. If you are selling 100 shares at $48, then the value of the shares is $4,800.)

1) I can choose to do nothing. This might be best if I think the shares are going to continue up for a long time or if it is a dividend growth investment that is core to my ongoing dividend income needs. I really like selling call options on investments that don’t pay dividends.

2) Perhaps I have 1,000 shares and want to sell 100 of them to lock in my profits. I want the money for some other investment. I can sell them for today’s price.

3) If I think the price will rise a bit more, I could enter a sell limit order to sell the shares if they reach $50 per share. For 100 shares I will receive $5,000 if the shares are called.

4) But I can also sell a call option contract and pick a higher share price for the contract like $50, $51, or even $55. The following table shows what the choices look like if I think a $50 price is a good price for my shares.

The Expiration Date of the Call Contract is Important.

An important concept is the expiration date of the contract. When I buy groceries, I look at the expiration date to see how long the food will last. A date farther out is usually best for some items. Options expiration dates matter to the seller and buyer as well.

The longer the time between when I sell the contract, and the expiration date of the contract, the more likely it is that the option will be called. This is especially true in a bull market when prices are rising.

It is best not to be greedy. I might only get $1 per share for a contract that expires this coming Friday. While I might receive $2 per share for a contract that expires on January 27, 2023, the risk increases that the shares will reach $50 by that date. That is why the call option buyer is willing to pay more. They are paying for days. The extra time in the contract’s life makes it more probable that they will buy your shares for a really good price. When all else is equal, the longer time you are willing to commit, the more the buyer will give you for your options contract.

Explaining the Table

Assume that I have 100 shares of the XYZ Corporation. The XYZ shares are trading at $48 per share. I could sell them for $4,800. But perhaps I would like to receive $5,000 for my shares. I could offer a $50 per share call contract to guarantee I would receive that amount for my shares. If I had originally paid $25 per share, receiving $50 per share would give me a wonderful profit of $2,500.

Therefore, if I sold a call contract to sell my 100 shares for $50 by December 30, and the price reaches $50, or more, on or before that Friday, the buyer of my contract will “call” for me to sell him (or her) my shares. So by selling a call contract, I am agreeing to sell my shares at an agreed-upon price of $50 at any point through December 30. He gets my 100 shares, and he pays $5,000 for the shares. Obviously, if the shares are trading for less than $50, he won’t want them. He is only out $100 and can try again next week or next month.

If the buyer of the call gave me $100 for my contract ($1 per share), then I already received $100. If the price of my shares rises to $51.00, I have already agreed to sell them at $50.00. Therefore, the buyer will “call” for me to sell my shares to him for $50 per share and the buyer will give me $5,000. The call buyer can benefit, and that is why they were willing to pay me $100 for the call I sold. If, for example, the price of the shares rises to $55 by December 30, they still only pay me the $5,000 for shares that are now worth $5,500. They are happy and I received the amount specified in the contract I sold. You see, they can immediately sell the 100 shares and make a profit of $500, less the $100 they paid me for the call option. So they made $490 in a very short period of time.

If, however, the shares remain at $48 or rise only to $49, or sink to $45, I get to keep the $100 and I keep my shares. The call buyer gets nothing for his $100 investment. My only risks in this type of trade are: 1) Missing out on a huge price increase by selling at too low of a price. But remember, I said I would be happy to get $50 per share. You have to have that mindset to trade call options. If you own quality investments, the other risk is less important: 2) The price of your shares drops and you get surprised by some bad news about the XYZ Corporation. There are ways to exit the trade or “roll” the call, but these are more complicated trades for a future post.

Is There a Secret for Success?

The main ingredient for success, if you want to keep most of your shares when selling calls, is to avoid being greedy. Don’t sell a call option that expires six months from now if you aren’t ready to lose your shares. Six months is an eternity in the stock market. If you want to have the option expire in April 2023, be thoughtful about the price you want for your shares four months from now.

There are other things to think about as well. If the XYZ company pays a dividend, and the Ex-Dividend Date is January 2, 2023, then if your shares are called on December 30^th you won’t receive the dividend. The buyer of your call will receive that dividend. If, for example, the dividend is $0.85 per share, it might be better to wait until January 2, 2023, to sell a covered call. That way you get the dividend and the income from the sale of your call option.

Ask “Why Do I Want to Trade Options?”

One of the members of the Fidelity Investor Community, with the community name “Investor-elect”, offers some sage advice. He acknowledges he isn’t an options expert, but he says you should consider your objective before you trade your first option: What is your objective?

Before you head down the path of options, do an assessment of your objective(s). Perhaps your objective is to create income from uninvested cash. If so, you might want to use put options. Perhaps you have cash and want to buy a position at a price that is lower than today’s price, so you sell a put option. It is also possible that I will receive dividends from my investments, but I would like more income from those investments. If so, I might sell covered call options.

He then goes on to say that maybe you aren’t certain what your objective or objectives are. That is OK for the short-term. He suggested strategies that I also suggest. The first one of the two is the best one for a beginner.

1. Sell Covered Call options on your dividend-paying and non-dividend stocks. It is like getting an extra dividend on your stock for some return while the stock sits in your account. You could do this every month for monthly income. Investor-elect calls this a synthetic dividend. This works for stocks that pay a dividend and stocks that do not. For example, SAVA does not pay a dividend, but I have received a synthetic dividend multiple times in 2022.

2. Sell Cash Secured Puts. It is a way to generate income on your cash. This approach means that you promise the buyer that you will buy the stock if it drops below a certain price. The buyer is willing to pay you a premium for your promise. If the stock falls below that agreed price the buyer will take your cash and give you the stocks. If not, you keep your premium and do something else with your cash. I am currently doing this with TSM and SQM.

My Options Trading Objective

My object is to sell covered call options on profitable stock positions with an average option profit of $150 per trade without sacrificing overall dividend income or portfolio strength. The numeric goal is to realize an average of $2,000 in additional income each week, or an annual total of $100,000 in additional income per year. If some shares are called away, reinvest the proceeds in other investments to continue the dividends and options income flow.

Links for Learning

I have found Investopedia to be a helpful place to learn some basics about various aspects of investing. Therefore, I plan to share at least one link in every post to help you with the basics. Bear in mind that Investopedia is not likely to tell you how to trade options. That is my job. But Investopedia is a good resource to learn some important concepts.

Today’s link is “What Is a Call Option and How to Use It With Example”

INVESTOPEDIA

Scripture About Treasures and Trust

“As for the rich in this present age, charge them not to be haughty, nor to set their hopes on the uncertainty of riches, but on God, who richly provides us with everything to enjoy. They are to do good, to be rich in good works, to be generous and ready to share, thus storing up treasure for themselves as a good foundation for the future, so that they may take hold of that which is truly life.” 1 Timothy 6:17-19

All scripture passages are from the English Standard Version except as otherwise noted.