Increasing my “capitalist” rankings by starting to trade call options

January 16th, 2009 · No Comments

I placed my first ever order for an options trade today which I think bumps me up a notch on the capitalist side of the capitalist vs. frugality discussion common to so many personal finance blogs these days. 🙂  Seriously though, it’s been a month or two learning process to where I felt comfortable doing this.  Here are some of the things I learned along the way.

Make money the old-fashioned way: earn it.

First, why would we (or you) want to trade options anyway?  Alot of people talk about frugality as being the path to wealth, but like a few others (an example), we’d prefer to focus our efforts on increasing income rather than cutting back too much on spending.  We want to think about it as “earn more than we spend” rather than “spend less than we earn.”   So one great way to do that is to maximize the return on assets we already have.  But how can we do that?  Well, most people, including my wife and I, have stuck to a “buy and hold” strategy for our investments.  But that means we only make money when they pay dividends or interest, or we wait until the price has gone up and then sell them.   Options are a way to earn money during the interim holding period.  (They can be used for much more than that, but that’s all we’re doing with them for now.)

So what does it take to use options trading in that way?  Well, if you’ve never traded options before, the first hurdle you have to overcome is to get approved by your broker to make option trades.  This right is not automatically granted when you open up a brokerage account.  Different brokers structure their permissions differently, but there are a few similarities between them.  For one thing, if you have no options trading experience then they will likely only approve you to do the most-conservative type of options trade called a “covered call”.  This is where you have to own shares of the equity in question before you can sell a “call” on it.  (A “call” is the right for someone to buy the equity at a fixed price.  You selling a call means that you’re being paid to accept a deal where you will sell the equity over some limited time period at an agreed upon price.)  This is the least-risky option trade you can make because you can’t lose money you don’t currently have.  (By which I mean the broker won’t end up having to collect additional money from you at some later point.  All the money you need to put in is in at the time you trade the option.)  Anyway, this level of options trading is all we’re approved for so we haven’t gone further than that level yet.

Now that we’ve been approved for options trading, the next thing we needed to realize is that each option covers 100 shares of the underlying equity.  That is 1 option = 100 shares.   Interestingly though, when we look up the prices at which options are trading at, the quoted prices (bid, ask, last trade) are per individual share.  i.e. A call option trading at $1.00 means that the trade is worth $100.00 ($1.00 x 100).  Said another way, if we sold a single call option at $2.00, we’d receive $200 minus trading commissions.   Anyway, the point here is that we can’t make a “covered call” trade unless we have 100 or more shares of an equity for which options are available.  Well, I guess that isn’t technically true because if we had enough cash we could do what is known as a “buy and write” trade whereby we simultaneously buy multiples of 100 shares and sell the call options to match.  In our case, it took us awhile of working our way to having 100 shares of something we wanted to hold that had a reasonable options trade.

So how do we figure out whether any covered call trade is going to make us money?  Well, the basic idea again is that we are selling an option to purchase the equity in question for a price higher than the current market price.  That is, someone is paying us for the right to buy shares in the future at a price higher than what we’re holding now.   We can think of this as lowering the cost basis of the equity by the net amount of money we made selling the call option.   If the market price of the equity drops lower than that cost basis, then we’ve still lost money by holding the shares (which we were doing anyway) but we’ve lost less than we would have lost if we hadn’t sold the option(s).  If the market price does anything else, we’ve made a profit by selling the option(s)!  The amount of that profit varies depending on the relative distance between our cost basis and current market price except for one thing.  If the market price has risen higher than the strike price of our option(s) (the price at which we agreed to sell our shares at), then we’ve lost out on potential profits we otherwise could have made by just holding the underlying equity.  That is, if we sold options for a strike price of $50 when the market price was $45 and the market price prior to the options expiration was $55, we still have to sell for $50 and get only $5 in profit (plus the money we made selling the option) rather than the $10 we could have made.

That mention of expiration is very important!  Something like 2/3rds of all options expire without being exercised, which in the case of our covered call trade, means we still get to hold the shares plus keep the money we made for selling the call(s).  We can then turn around and sell a new covered call if we want to lower our cost basis even further.   However, our ability to avoid someone exercising our call option is somewhat dependent on us having picked a strike price that is above the volatility of the underlying equity, or above what we think it’s price will move to during the term of the option.  If the option does get exercised, in most cases the brokerage takes care of automatically transferring our shares and crediting us the cash for the strike price we agreed upon.  i.e. if we sold 1 call option at a strike price of $50, the broker would take our 100 shares and give us $5000 (minus the transaction cost) in our account.

Very important!  Make sure you’ve checked what the transaction cost is on an options exercise.  For some brokerages (Zecco and Fidelity for sure but there are others) the cost is the same as other equity trades like simply selling an existing position.  However, some brokerages charge higher fees (like ShareBuilder which charges something like $20, or even $30 should your counter-party opt for an early exercise.)

I could go on about this, but I think I’ve rambled long enough for one post.  One last thing though, I recommend using a limit order when making your option trades (especially when you’re first starting out.)  This protects you from a number of things (low volume, market changing faster than you thought, etc.)  Oh, and I just checked and apparently my trade didn’t get filled today.  I guess I had too high of a limit set.  Oh well, next time. 🙂

Tags: Brokerage · ETFs · Options

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