Saturday, August 24th, 2019

Occasional Options Trading

 

There are two kinds of folks who trade options. There are full time options traders for whom options trading is their business. Then there are people who have other full time work for whom options trading occasionally makes sense. If you do not engage in options trading full time when might you sell a call option or buy a put option?

Some years back Amazon.com was considered by many to be a good stock for which to sell a call option.  Options trading in Amazon.com was often successful because the stock went through a number of cycles which, to a degree, became predictable. Thus, an owner of Amazon.com could wait until the stock was at the top of the cycle and then sell a call option. The stock would not go up so the owner retained the stock and gained a premium. He or she could sell a call option on the stock each time the stock reached the top of its cycle.

To sell a call option means that you sell the right but not the obligation to buy a stock. Typically it is a stock that you own, as in the above example. If the stock goes up the buyer of the option exercises the option at the strike price, which is the original price of the options contract and owns the stock at the spot price, the current market price. Selling when you own the stock is called a covered call and selling when you do not own the stock but firmly believe it will go down in value is a naked call. To sell a call option naked is the business of full time traders who can watch the underlying stock closely. If you business does not let you follow the market all that closely you only want to sell a call option when covered, that is, when you already own the stock.

The risk of this kind of options trading, to sell a call option when covered, is that if the stock breaks out of its cycle to the upside you lose out on the gain, retaining only the premium. But, for the longer term investor who does not have the time or expertise to engage in full time options trading, to sell a call option on occasion can be profitable.

Another example of occasional options trading that can work is with an investor who gets into a growth stock early and sees his or her investment multiply in value. The investor is concerned that the stock will “correct” and wipe out a large fraction of his or her gains. However, he or she does not want to sell the stock as the investor believes the stock has the potential to go up farther. Options trading can help in this situation. The investor can buy a little insurance, so to speak, by choosing to buy a put option.

Unlike when you sell and call option and someone else has the right to buy the stock, when you buy a put option you are buying the right, but not the obligation, to sell the stock at the strike price, the price of the stock at the beginning of the contract. If the stocks drops precipitously your insurance pays off and you exercise the option. If the stock does not move you have paid a little insurance in the form of a premium and still retain your stock. If the stock goes up you have a potential profit, minus the insurance value of the premium. To buy a put option when you own the stock works when you expect a volatile market and want to insure against downside risk while preserving upside possibilities.

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