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An Introduction to Stock Options
You probably know that there are two ways to earn profits in the stock market: cashing in your dividends or earnings per share (EPS) and earning capital gains by buying and selling stocks. But did you know that you can earn money even if you don't actually have to buy or sell those stocks? You only have to write options. What do I mean? Read on.
Options
So you already met with your broker, told him to buy 10,000 shares of stock from one of those blue chip corporations. You soon realize that the corporation barely pays its dividends and the share price barely moves at all. In the meantime you are looking to earn some cash. How? Well, you can write covered calls. Options are contracts that you sell that give its holders the right to buy (or sell) your stocks at a given strike price, within a given period of time. An option to buy your stocks is called call. An option to sell your stocks is called put. It may still be confusing but I hope this illustration helps.
Covered Calls
Let's take your example. Assuming you own 10,000 shares of Microsoft. You want to earn money so you write covered calls. A call option gives its holder the right, but not necessarily the obligation, to buy 100 shares of stock at a specified strike price, within a specified period. Let us assume that Microsoft has a current share price of $28.37. There is some speculation that 3 months from now Microsoft's share price would balloon to $38.37. You don't believe this considering that one year has passed and nothing big happened to Microsoft's share price. Hence you write a call which says that if Microsoft's share price reaches $33.37 (the strike price) you will sell 100 shares of Microsoft stocks to the holder of the call, starting now until 3 months after. Each contract would be $0.02 per share. This means that for the small price of $2, the buyer of your call option can possibly buy 100 shares of Microsoft stock for only $33.37 each, regardless of whether the actual share price balloons to $38.37 or even $40 within the next three months. Since you have 10,000 shares you can sell 100 call options (with 100 shares per contract) giving you at least $200. Remember that the call option may or may not be exercised by the holder of the call option. This is because Microsoft's share price may or may not reach the strike price, which is $33.37. If it was exercised, you have the obligation to sell your 10,000 Microsoft shares at $33.37 each.
It is also good to know that strike prices, or the equivalent price in which your call option can be exercised, is determined by the Options Clearing Corporations. Just like in stocks you sell options to the market maker, who in turn sells it to an interested buyer. Of course, there is still the customary spread for the market maker. It is also good to know that the call you sold is called covered call because you actually own the stocks that you could possibly be required to sell. In reality there are naked calls in which call options are written where the writer doesn't actually own the stocks. When that call option is exercised he must produce those stocks, even to the extent of buying them in the stock market.
Writing calls is a good way to earn money but at the same time you risk losing your stocks which might increase in share price. In the end you decide how risky or not selling of options can be.
Options
So you already met with your broker, told him to buy 10,000 shares of stock from one of those blue chip corporations. You soon realize that the corporation barely pays its dividends and the share price barely moves at all. In the meantime you are looking to earn some cash. How? Well, you can write covered calls. Options are contracts that you sell that give its holders the right to buy (or sell) your stocks at a given strike price, within a given period of time. An option to buy your stocks is called call. An option to sell your stocks is called put. It may still be confusing but I hope this illustration helps.
Covered Calls
Let's take your example. Assuming you own 10,000 shares of Microsoft. You want to earn money so you write covered calls. A call option gives its holder the right, but not necessarily the obligation, to buy 100 shares of stock at a specified strike price, within a specified period. Let us assume that Microsoft has a current share price of $28.37. There is some speculation that 3 months from now Microsoft's share price would balloon to $38.37. You don't believe this considering that one year has passed and nothing big happened to Microsoft's share price. Hence you write a call which says that if Microsoft's share price reaches $33.37 (the strike price) you will sell 100 shares of Microsoft stocks to the holder of the call, starting now until 3 months after. Each contract would be $0.02 per share. This means that for the small price of $2, the buyer of your call option can possibly buy 100 shares of Microsoft stock for only $33.37 each, regardless of whether the actual share price balloons to $38.37 or even $40 within the next three months. Since you have 10,000 shares you can sell 100 call options (with 100 shares per contract) giving you at least $200. Remember that the call option may or may not be exercised by the holder of the call option. This is because Microsoft's share price may or may not reach the strike price, which is $33.37. If it was exercised, you have the obligation to sell your 10,000 Microsoft shares at $33.37 each.
It is also good to know that strike prices, or the equivalent price in which your call option can be exercised, is determined by the Options Clearing Corporations. Just like in stocks you sell options to the market maker, who in turn sells it to an interested buyer. Of course, there is still the customary spread for the market maker. It is also good to know that the call you sold is called covered call because you actually own the stocks that you could possibly be required to sell. In reality there are naked calls in which call options are written where the writer doesn't actually own the stocks. When that call option is exercised he must produce those stocks, even to the extent of buying them in the stock market.
Writing calls is a good way to earn money but at the same time you risk losing your stocks which might increase in share price. In the end you decide how risky or not selling of options can be.
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