Tuesday, July 17th, 2018

Options, Dividends, and Volatility

 

There is an excellent discussion of specific options trades in the current online issue of Forbes (http://www.forbes.com/sites/stockoptionschannel/2013/11/11/interesting-april-2014-stock-options-for-cisco-systems/). The article discusses put and call options for April 2014 for Cisco (CSCO). At issue are the price of the put option or call option, the dividend paid by Cisco, and potential market volatility. This is an article for investors who may wish to sell puts or call on the stock and want to do the arithmetic on how much they will gain or lose using various scenarios. It is an excellent example of the fundamental analysis of options in cases in which picking options is just matter of arithmetic. Our take on options, dividends, and volatility follows.

Options Price and Anticipation of Price Changes

As a rule, options writers make more money than those who purchase options. Selling puts can lead to devastating losses if a stock falls markedly and leads to lost opportunity if the stock soars in value. The options trader will want to account for premiums on options, dividends, and volatility. For example, when an investor sells calls and puts on a basically stable stock such as CSCO he limits his risk. When selling puts and calls on a large cap stable stock it is often simply a matter of doing the math. For a refresher on how this is done read the Forbes article. If you are thinking of selling calls and puts in a volatile market on volatile stocks you had better have deep pockets because of the risk of an occasion very large loss. In online options trading remember the triad of options, dividends, and volatility.

Adding to Your Dividend and Calculating Return

Selling calls and puts on a stable stock that you own can be a good way to add a little cash flow on top of your quarterly dividends. If this is a stock that you have held for a long time you probably have a good idea of what range it trades in. You likely have a good idea of the odds of it rising or falling in price. For example, you may find that there is reasonable premium available at a reasonable strike price for either a call or a put on a stock that you own. After considering premiums on options, dividends, and volatility you sell a put or a call or both. The stock stays at pretty much the same price as when you sold the options contracts. When the contract expires you have pocketed the premium for the put or call or both and perhaps have received a dividend payment or two. If you pick the right contract on the right stock you may double your dividend or do even better.

Missing Out on Opportunity

The ever-present risk of selling a call contract on a stock that you own is that you can miss out on the rally of the century. The stock will be subject to a takeover bid or will benefit from the introduction of a brand new product and rise in multiples of the strike price at which you sold. Along the way you will have gained the premium for selling a call contract and even a dividend or two but will miss out on just why it is that many folks own stocks. It is all about accounting for options, dividends, and volatility.

Losing Your Shirt with Put Options

When you sell a put option on a stock you own you run the risk of having to buy more of the stock at the strike price when the price is falling dramatically. This can be very costly and is why many investors only sell calls on stocks that they own and virtually never sell puts.

Options and Volatility

Buyers of options contracts hope for volatility and sellers hope for a stable market. The math for selling options is easy if you assume little volatility and predictable dividend yields. There are kinds of options trading that offer great reward but also great risk. And there are kinds of trading that are more manageable and offer predictable but smaller gains. When there are good premiums on options, dividends and volatility will determine if selling calls or puts is a good idea.

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