What Are Your Options on Options?

What is the difference between selling a put and buying a put? Or buying out-of-the-money call options? Or selling a covered call? If you’re in the brokerage business, then you had to suffer through a number of questions on options when you took your Series 7 (aka FINRA). Now you’ve forgotten most of it. This is a refresher.

The best definition for options I can find comes from an investment and alert bulletin issued in 2015 by the Securities and Exchange Commission. They are concerned clients are getting fleeced in the options market. I’m shocked to hear this, and I’m sure you are too. ¹

• Options are contracts giving the owner the right to buy or sell an underlying asset, at a fixed price, on or before a specified future date
• Options are derivatives (they derive their value from their underlying assets).  The underlying assets can include, among other things, stocks, stock indexes, exchange-traded funds, fixed income products, foreign currencies, or commodities. ¹

If you have clients who are trading options or want to trade options, “puts” and “calls” are usually the type of options they will utilize. Once again, the best and most concise definition comes from the SEC:

• A call option is a contract that gives the buyer the right to buy shares of an underlying stock at the strike price for a specified period of time. 
• Conversely, the seller of the call option is obligated to sell those shares to the buyer of the call option who exercises his or her option to buy on or before the expiration date.
• A put option is a contract that gives the buyer the right to sell shares of an underlying stock at the strike price for a specified period of time. 
• Conversely, the seller of the put option is obligated to buy those shares from the buyer of the put option who exercises his or her option to sell on or before the expiration date. ¹

Why would a client want to trade options? Many reasons. First, a percentage of your clients see the stock market as akin to a casino. Clients must be nimble when buying and selling options because they can easily lose their shirts and lose them quickly. Some people really like that feeling.

In my observations over the years, two types of people trade in the options markets for stocks: sophisticated investors and your standard issue “adrenalin junkie.” Skydiving, bungee jumping, and surfing killer waves are different ways adrenalin junkies get a super dose of adrenalin. For many thrill seekers, buying and selling options on stocks unquestionably provide the same high.

Your other type of option trader is the sophisticated investor seeking to wring out the last bit of value from his or her portfolio without taking significant risk. The standard option trade for this person is to sell covered calls which means they own the underlying stock.   

Example: Ms. Gotrocks, owns 50,000 shares of the Kryptonite Mining Corporation which is trading at $100 per share. She sells or writes call options which expire in three months on 10,000 shares of Kryptonite. The strike price on the three-month calls is $120. This means her stock can get “called” away from her if Kryptonite stock closes at a price higher than $120 when the options expire.  

Since she owns the underlying shares, this is a “covered call,” the most conservative play in the options market. Ms. Gotrocks sells the calls because she believes the stock is a dog and isn’t going to go anywhere. She receives a premium for selling her covered calls which increases her income.

Counter-parties who think the price of Kryptonite will be much higher than $120 at the expiration of the options in three months buy the call options Ms. Gotrocks is selling. In three months if the price of the stock has risen to $130, then her stock is called at $120. The person who bought the option contract (the holder) gets the stock, sells it for $130 and collects the difference between $120 and $130.

Trading options is normally substantially more complex than what I have described, but this will give you the basics. Depending on the policy of your firm, selling covered calls can be profitable to both the FA and the client. Or not. But for clients looking for extra income, it can be a useful strategy.

Copyright ©2018 Cannon Financial Institute - All Rights Reserved

Subscribe to Cannon Insights at http://www.cannonfinancial.com/newsletter/subscribe

Resources: 

1 https://www.investor.gov/additional-resources/news-alerts/alerts-bulletins/investor-bulletin-introduction-options

Contributing Writer: Subject Matter Expert Charles McCain