I feel like the Johnson and Johnson vaccine. Overly ambitious (a one and done, no booster shot needed), battered (the blood clots really weren’t that bad – we didn’t need a 10 day pause) and yet, against all odds, an apparent success (it is being injected into arms to this day). 

This was a stretch. But so was me trying to learn and simultaneously teach options trading. However, today is one of celebration for this is the last time I am going to utter the word “options” in regards to finance for at least another 10 months. If you’ve been reading these, you are an absolute star. Pour yourself a glass or 7 of natural wine. I certainly have. So, apologies in advance for any bumbling about with this one. (To my boss: obviously kidding).

To go over what we know:
Buying options gives you the right to exercise that option (to buy/sell a stock) at any time prior to expiration.

In turn, when you write (aka. sell) an option contract, you are creating it. The seller of an option collects and keeps the premium received from its initial sale. When you write an option contract, you can be assigned an exercise notice at any time during the life of that contract. Meaning: the buyer would have to pay up whatever number of shares they purchased of the underlying security, and return that back to you upon notice. 

However, it is of note that only about 7% of all option contracts are ever exercised. The majority of the trades exist in the realm of buying and selling the options with no aim of actually owning the shares of a given company. 

 


All option trading boils down to 4 main positions:

(The visual is back because I am going to mess about with some math here – if this isn’t an act of love, I don’t know what is).

 

1. Buy a Call: Buying a call gives investors the right to purchase the underlying stock at the strike price on or before the expiration. Way more common though, and if things go as planned, the investor will be able to buy the stock and subsequently sell the stock at a profit at some point before expiration. 

The why: The investor buys calls as a way to profit from expected growth in the underlying stock’s price without the risk and up-front capital outlay of outright personal stock ownership. The smaller initial outlay (just the premium, rather than the stock price at time of option purchase)  also gives the buyer a chance to achieve greater percentage gains (someone say – leverage).

Hypothetical:
Stock Price: $125
Trader’s Prediction: In 30 days, the stock price will be at, at least, $135
Option Trade: You buy the 130 call for 2.50 (which, remember to drop the decimal = $250 total cost)
Redundancy: You have spent $250 for the opportunity to speculate the stock will have a significant gain in the next 30 days
Outcome: It’s been 30 days and, you were right, the stock is now trading at 135.
Math: The stock went up $10.00 ($125 to $135). 

Because the contract purchased was a 130 call and the stock is now $5 beyond that, the option is $5 in the money (i.e., $5 beyond the strike).
Which, (because 1 option contract = 100 shares) = $500 in profit
You made $500 and you spent $250 (hello grade school math) so…
On the last day before expiration, you sell the contract and walk away with $250.
You doubled your money. 

*Risk level: low. If the stock doesn’t go up, you lose the premium you bought it for (so, the maximum risk is what you paid for it). In a different hypothetical situation, say, if the stock stayed at 125, you would’ve only lost the $250 premium and the option would expire worthless. 

 


 

2. Sell a Covered Call: When you sell a call to somebody, you give them the right to purchase stock from you at a specific price. 

The why: This is a way to generate money on stock that you own and plan on owning long-term. In other words, you plan to make money off the long-term growth of the stock, so you’re not worrying yourself with the temporary highs and lows of the stock price. You’re going to be making money off dividends (if that’s offered) in the interim, but why not loan that stock out to someone else and make some money off that while you’re at it? A performance enhancer, if you will. 

(For another metaphor: Think of it like a rental property…you’re not living in the house, just holding onto it for eventual sale. While you wait, you may as well let someone rent it and earn some extra income – i.e. the premium)

*If you don’t already own the stock, that’s called selling a naked call. We’ll cover that when I’ve recovered. 

Hypothetical:
Stock Price: $125
The Seller’s Prediction: In 30 days, the stock price won’t rise spectacularly.
Option Trade: You sell the 140 call for 0.50 (which, remember to drop the decimal = $50 total price tag)
Redundancy: You have made $50 on the option trade, expecting  that the stock will not get above the 140-strike price in the next 30 days.
Outcome 1: It’s been 30 days and, you were right, the stock is only trading at 130. The stock is below the strike price, so you get to keep your $50 premium and be on your merry way. The buyer will not exercise the contract (why would they? They can go out and buy the stock on the market for 130 instead of 140). Outcome 2: It’s been 30 days and, you were wrong, the stock climbed to 145. So…math
Math: Because the contract is now in the money ($145), it is exercised at $140.

The result for you, as the seller, is:
You had bought that stock at $125 at a previously unspecified time,  and the option you sold was exercised y at $140. The buyer therefore gives you $140/share, resulting in  $15 profit / share for you. (Their profit is $5/share)
You sold the option which added another $0.50
So, you made $15.50 per share.
And, (because 1 option contract = 100 shares) = you’ve made $1,550

*Risk level: very low. If the stock doesn’t go up, you’ve gained the premium. If it does go up past the strike price, the contract will be exercised, and you make up the difference from where you bought the stock to where you sold it (i.e., 125 to 140). You make money either way. 

 


 

3. Buy a Put: Buying a put gives investors the ability to profit from a stock downturn or can act as a form of insurance (hedge) on a stock already owned. Let’s say, for our purposes, we are buying a put as a form of insurance…

The why: If you owned a stock in January of 2020 (the last days of freedom) and saw the potential catastrophe that was Covid-19 barreling our way, you may have thought it wise to protect your position that you’re intending to hold long-term. But in the short-term, your investment in movie theatres is at risk of plummeting. You buy a put option to ensure that, if the stock does plummet (remember our definition) you “have the right but not obligation to sell stock at an agreed upon price on or before a particular date”. The stock could drop to $0, but you have bought a put option that allows you to sell your shares, if you so desire, at the given strike price regardless of the price on the actual market. 

Hypothetical:
Stock Price: $125
Trader’s Prediction: In 30 days, Covid will annihilate our stock and the price will drop to $50.
Option Trade: You buy the 125 put for 5.00 (which, remember to drop the decimal = $500 total cost)
Redundancy: You have spent $500 (like insurance) to ensure that if the price tanks, you can still sell your shares at the price they are at now: $125.
Outcome: It has been 30 days and, you were sort of right – if slightly too pessimistic, the stock is now trading at 100.
Math: The stock went down $25.00 (125 to 100). 

Because the contract purchased was a 125 put and the stock is now $25 below that, the option is $25 in the money (i.e., $25 beyond the strike).
Which, (because 1 option contract = 100 shares) = $2,500
You made $2,500 and you spent $500 so…
On the last day before expiration, you exercise the contract, sell your shares, and walk away with $2,000. 

*Risk level: low. Reference above risk of buying a call. The maximum loss is only the premium paid. 

 


 

4. Sell a Naked Put: If buying a put is like a customer buying insurance, selling a put is the insurance provider. And what does your insurance provider do for you? Take on the extra risk and cost in case something goes south. You don’t own the stock just as any insurance provider doesn’t own your house…You just have to be prepared to pay up in case of bad news. 

The why: There are 2 reasons. One, the seller doesn’t think the stock will drop and she’s just generating easy money (premiums! In the same way insurance hopes you never have that house fire because then they have to pay you out). Two, the seller is willing to provide the stock at the strike price and would prefer the immediate gain from the premium. 

Hypothetical
Stock Price: $125
Seller’s Prediction: In 30 days, the stock price won’t drop to $115.
Option Trade: You sell a 115 put for 1.25 (which, remember to drop the decimal = $125 total cost)
Redundancy: You have immediately made $125 on the premium from the option trade, with the expectation that the stock will not go below the 115-strike price in the next 30 days.
Outcome 1: It’s been 30 days and, you were right, the stock is still trading at 125 or higher. The buyer will not exercise (why would they sell to you at a lower share price than on the market value?), you walk away with your cute little premium and that’s that.
Outcome 2: It’s been 30 days and, you were wrong, the stock dropped to 100. So…math.
Math: Because the stock is now trading at $100, the option contract is $15 in the money ($115). 

The result for you, as the seller, is:
The girl who bought the insurance from you is going to exercise the policy and make you take the stock from her at $115, as per your agreement. Unfortunately, since the stock is now at $100, you have to buy it back at $15 above what it is trading at.
You made $125 on the premium, but lost $1,500 on the stock trade…
So, you have lost $1,375. 

*Risk level: high. The stock might not only dip but plummet well below the strike price that you sold the contract for. In this case, you are obligated to honor the contract (the insurance) and buy that stock at the  significantly higher strike price than its ending value. (Leave this to the experts). 

 


 

Goodbye and good riddance:

As if all of that was not complex enough…there are a million other niggly options trading strategies that take all of the above and combine, flip and reverse them (ugh). I know there is even a ‘strategy’ that consists of buying a call and put on the same stock, which, in my mind, obviously, seems counterintuitive. Like saying “I can’t not finish this article” – the double negative cancels itself out. Luckily, we are not out here becoming options trading savants, but rather, options trading we-sort-of-understand-the-very-broad-concepts-regular-people-go-take-a-course-from-somebody-accredited-if-you-want-more. 

(Editor’s note: actually going to make her come back to explain naked calls/puts, send her bitcoin if you feel bad for her)

So, I will leave you with some absurd option strategy names that some very serious grown-up people call their very important money-making work – ranking them solely on how they make me feel:

Calendar spreads (this is what the above double negative nonsense is called, scary math – 2/10)
-Protective Collars (cute, makes me think of puppies – 8/10)
-Condors (a word also defining the largest flying bird in the Western hemisphere – horrifying – 0/10)
-Butterflys (very quaint Wall Street! – 9/10)
-Strangles (unnecessarily aggressive tone to this – 4/10)
-Straddles (a good hamstring stretch – 6/10)
-Synthetics longs (feels like a new-age legging that I would take no part in – 3/10)

 

Hallelujah, we are done. Options: goodbye and good riddance. 

Until next week.

 

Written By:

Madelyn Grace

Maddy has graciously allowed the Equity.Guru audience to take a look into her investor education journey - and is here to ask all your questions, with a heavy dose of millennial cynicism and good humour (swear it's not oxymoronic). With an EngLit degree from Ryerson University, and a pedigree that includes having been killed on CW series Supernatural twice, she fits right in with the rest of the Equity.Guru team, making even the most dull financial topic approachable. Talk to her about feminism, the acting world in Vancouver and all your financial woes. Don't talk to her about pineapple on pizza, NFTs, or how cheesecake is really a pie.

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