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Stock Options Investing Guide
Posted by John Schroeder Last updated on April 17, 2020 | Stocks
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T rading stock options is one of the most profitable ways to invest in the stock market.
It is also one of the riskiest strategies that could wipe out an entire portfolio in a very short amount of time.
Buying and selling stock options is certainly not a beginner investing strategy, but is one that could slowly be added to an overall investment portfolio over time.
As an investor gains experience in the stock market and is looking to add some additional risk, stock options may be a viable investment tool.
So what exactly are stock options and how are they different than traditional assets that are bought and sold?
Table of Contents
Definition of a Stock Option
According to Investopedia, a stock option is:
A privilege, sold by one party to another, that gives the buyer the right, but not the obligation, to buy (call) or sell (put) a stock at an agreed-upon price within a certain period or on a specific date.
Based on this definition, there are four key points that investors need to learn when it comes to stock options.
- the right, but not the obligation
- to buy (call) or sell (put) a stock
- agreed upon price
- within a certain period or on a specific date
Each of these points uniquely defines how a stock option works and are each explained in more detail below.
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Buyers Have the Right but no Obligation
Very few investments give the buyer of an asset (i.e. stock) the right to purchase without any obligation.
For example, when an investor purchases a stock, they immediately own the asset until they decide to sell it. There is an obligation to own the stock once the investor places a trade and it is filled.
Buying a call option, on the other hand, gives the investor the power (or right) to purchase the same stock at a later date at a predetermined share price.
In return for this right, the buyer is required to pay a premium that is then transferred over to the seller of the option.
So while the buyer of the option must pay this premium, they are locking in a future price of a stock that may increase or decrease.
Here is an example of how buying a call option works:
Say you are interested in purchasing 100 shares of a hypothetical company known as ABC.
While you have the money to invest, you are not sure if you want to completely tie your money up in a single investment.
Since shares of ABC are trading over $50 per share, you would need to come up with at least $5,000 to place a buy order to purchase the stock.
Another possible solution to hedge against future prices is to purchase 1 call option (1 option contract = 100 shares of stock) of company ABC.
An investor who purchases this type of call with a strike price of $50 is locking in the option to buy 100 shares of the same stock at a future date.
At this point, the investor is only out the premium paid to purchase this right and could let the contract eventually expire.
There is never any obligation to purchase the stock in this scenario.
Types of Options – Explaining Calls & Puts
While there are plenty of option trading strategies, there are only two types of options which are referred to as calls and puts.
Remember that purchasing a call gives you the right to purchase a stock at a fixed price within a set time. A put, however, gives you the right to sell a stock at a fixed price within a set time.
From the ABC example above, the investor chose to purchase a call option which gives them the right but not the obligation to buy the underlying stock for the agreed upon price.
Buying a call option is typically viewed as a bullish strategy where the investor believes the stock price will increase over the next few months.
On the other hand, if an investor becomes bearish on a stock, they could purchase a put option. Purchasing this type of asset gives them the right but not the obligation to sell 100 shares of stock back to the seller for the agreed upon price.
This strategy works well when a stock drops in price as the buyer of the option can purchase 100 shares of stock at the current price and turn around and sell them at a huge premium.
Stock Option Strike Price Explained
T he strike price, also known as the exercise price, of a stock option, represents the price at which an option contract can be exercised.
For a call option, it signals the share price where the underlying stock can be purchased.
The strike price of a put option represents the value at which the underlying security can be sold.
This fixed price represents the amount at which a stock can be purchased on a call option or sold on a put option. Most of the time, strike prices are found in $2.50 or $5.00 increments, depending on the underlying stock.
Companies that tend to have a lower price per share usually increment by $2.50 whereas higher priced stocks increment by $5.00. Stock splits and the timing of when option contracts are set also play a factor in how a strike price is set.
In the example above, the investor decided to purchase a call option at a strike price of $50.
This price always remains static, unlike a share price that fluctuates each trading day. The main purpose of the strike price is to allow an investor to lock in a future purchase price of a stock on a call option and a future sale price on a put option.
Note – The price that an investor actually pays for an option is not the strike price, but is the premium.
Valuing the Option Premium
It is important to understand the difference between the strike price of an option and the premium. The strike price always remains static throughout the entire option contract. As mentioned earlier, this is the price at which a stock can be purchased or sold depending on the type of option.
The option premium is the amount of cash that is paid to the seller of the contract. This payment gives the buyer of the option the right (but not the obligation) to buy (call) or sell (put) the underlying stock.
While the premium and strike price represents two different values, the strike price actually helps to determine the premium along with other factors.
For a call option that is out of the money, the higher the exercise price is set the lower the premium. On the other hand, the further an option is in the money the higher the premium. There are also other factors that help determine the premium of an option (like the expiration date), but the strike price is very important.
The premium for put options is also impacted by the exercise price. As a stock trades lower away from the strike price, the premium becomes higher. On the other hand, as the stock increases in value, the premium becomes worthless.
Why Understanding the Stock Option Strike Price is an Essential Concept
The strike price is an important concept to understand for investors looking to trade calls and puts. It simply represents the value in which a stock can be purchased (call) or sold (put) at.
The exercise price plays a large role in helping to value an option contract which is referred to as the premium.
What’s “In the Money”?
A call option that is in the money has a strike price that is lower than the current price of the underlying stock. The owner of this type of option would have the right to exercise the contract and purchase shares of the stock for less than the current share price.
For example, a stock trading at $20 may have a call option with a strike price of $15. The owner of the option would have the right to exercise the option and purchase shares of the stock for $15, even though the current price is much higher.
The investor would then be free to sell the stock for the current share price ($20) for a $5 profit or hold it for a longer period of time.
In the Money Puts
An in the money put option has a strike price that is above the current price of the stock. In this case, the owner of the option would have the right to sell shares of the underlying security for more than the current traded share price.
A stock trading at $35 per share that has a put option of $40 would be considered in the money. The owner of the put option could sell back the shares of the stock for a $5 profit per share in this scenario.
Deep In the Money Options
At times, both put and call options can fluctuate between being considered in the money or out of the money depending on where the stock is trading.
This is why many options investors search out contracts that are considered to be deep in the money. A deep in the money option is generally considered to be at least one strike price above or below the current share price.
Both put and call options that are deep in the money tend to carry less risk and are valued much higher than contracts with a strike price at or near the share price.
Unlike a stock, every option will eventually expire and become worthless at some point in time if it is not exercised. This point in time is known as the expiration date. There are several scenarios that can play out on or before this date, depending on the type of option and the direction the underlying stock is trading.
It is extremely important for new options investors to fully understand the concept around expiration dates. All options have a time value factored in and become less and less valuable as the expiration date draws closer.
Why is the Expiration Date Important?
The expiration date is an important part of defining a stock option and the value (or premium) that is tied to the contract.
For starters, an investor who has purchased a call or put that lets their contracts expire will have wasted their entire investment. An option that expires without being exercised becomes worthless after the expiration date.
The expiration date also plays a crucial role in helping to set the premium for the contract. For example, an out of the money option (put or call) that has 6 months till expiration is usually worth more than one that has 3 months till expiration.
The option that doesn’t expire for 6 months is considered to be worth more because it has more time to become in the money.
This concept is usually referred to as time value.
As you can tell, the expiration date plays a critical role in determining the premium of an option.
Option Trading Strategies
Any successful investor will include the expiration date into their option trading strategy.
In some cases, there are strategies where the investor looks for options that are set to expire very soon. For example, an investor who sells covered calls will normally pick out options that are set to expire in the next one or two months.
This is because investors are looking for call options that are out of the money but still are close enough to the strike price to hold some value. The main goal of a covered call trader is to actually hold onto their stock while earning the premium that was paid.
Another option trading strategy may target deep in the money call options that have several months to expiration.
The bullish strategy here is to purchase call options on quality stocks that are well in the money that has very little chance of becoming out of the money. The investor then waits for a positive run-up in the stock and sells the call option back for a higher premium than what they originally paid.
The difference in the purchase price and the sale price is the profit earned by the investor. The bottom line here is that the expiration date is a critical piece of data used by the investor to implement their strategy.
Steps to Selling Covered Calls
There are a few important steps that you need to be aware of when selling covered call options. Here is an oversimplified list of steps an investor needs to take in order to successfully implement this basic options strategy.
- Buy the Stock – In order to be “covered” on your trade, you first must own the underlying stock. Remember that for every option contract you sell, you must own 100 shares of the stock. Your broker will not allow you to place the trade without these shares in your brokerage account. A broker will also require special approval in order to trade options, so a standard online brokerage account may or may not offer this feature.
- Find ‘Out of the Money’ Options – It is helpful to look for call options for your stock that are out of the money. A call that is out of the money will have a strike price that is higher than the current share price of the stock. For example, you may find an option for a stock with a strike price of $55 and the share price is currently at $50. This contract would be out of the money until the share price hits $55.01. Once that threshold is passed, then the option contract is considered in the money.
- Look for Soon to Expire Contracts – Another important step that can be used to limit your risk is to look for soon to expire call option contracts. Most investors who sell covered calls don’t actually want to lose the stock and would prefer it to expire without being exercised. Since options are time sensitive, the seller should look to limit the total time the option is open. It is a good rule of thumb to look at call options that expire no more than 2 months out.
- Analyze the Potential Trade – Even though you may have found a call option that is out of the money and expires in less than two months, it is important to analyze the trade. For example, if a potential covered call option trade will only net you $20, then it may not be worth risking your shares. Take the time to calculate how much you will profit from the trade and what would happen if your call option is exercised.
- Place the Sell Order – Once the analysis has been completed on the call option and the trade seems favorable, it is time to place the order. Work with your online discount broker to place a sell order to open transaction.
Final Thoughts on Stock Options Trading
In order to become a successful term-term options trader, an investor must spend time learning the basics.
The five points listed above are the basic building blocks that define what stock options are.
One of the most important things to remember is that purchasing a stock option (call or put) gives the buyer the right to buy or sell a stock with no future obligation. This is much different than what most stock investors may be used to.
A call option is a bullish strategy used to hedge against future share price increases. For those investors who are bearish on a stock, they can trade put options which can help hedge against future decreases in the share price of a stock.
As you can probably tell by now, there are a lot of components to learn when it comes to options trading. While they do come with a high level of risk, trading options can be very profitable.
Utilizing a top-quality brokerage makes the process much less daunting. If and when you are ready to invest in options, here are a few of my favorites:
Ally Invest provides a great options investment vehicle that is worth a look. Utilizing cutting-edge tools, the platform is able to provide it’s users with in-depth analysis of their investments. A price of $.50 per options contract makes Ally Invest a solid choice for the prospective trader.
Zack’s Trade is a great investment platform for the advanced investor – which makes them a great choice for options trading. Providing expert support and competitive rates on options contracts ($.75) causes Zack’s Trade to make this list.
E*Trade has been an industry-leader for over two decades. The company has developed an easy-to-use app for trading on-the-go. Plus, $.50 options contracts is a great value.
The Story Of Option Products
Options are one of the most important financial derivative contracts. Derivative is a financial contract between two or more financial entities such that its value is calculated from the price of its underlying security.
Understanding Options Will Help Us Invest Our Money Better
In this article, I will outline:
- Option basics and characteristics
- Options types
- Factors that impact options price
- How to calculate pay off profiles
- Lastly it provides an overview of put call parity
Please read FinTechExplained disclaimer.
What Is An Option?
Think of an option as a contract that lets you, the option holder, buy or sell an asset without any obligation. It’s your choice if you want to exercise the option. The underlying asset of an option could be stocks, foreign currency or indexes (cash settled on indexes e.g. S&P) or interest rates or commodities or futures etc.
Option holder is usually a counterparty such as a bank or an exchange or broker etc.
Option holder pays premium to buy option contract. If option holder does not exercise the option then he/she loses the premium.
Value of an option is derived from price of its underlying asset e.g. commodity, cash, interest rate swap etc.
What Are The Two Sides Of An Option?
There are two sides or legs of an option deal:
1. Buyer side — one who buys (longs) an option is the option holder.
2. Seller side — one who sells (shorts) an option is the option writer.
Option Forms: What Are Call and Put Options?
There are two basic forms of options:
Gives holder of an option right to buy a stock at a certain price on a specified date. This means option can never be priced more than the stock. If a call option is priced more than its underlying asset then an arbitrageur can make a profit by buying stock cheaper and selling call option at higher price without taking any risk.
Gives holder of an option right to sell a stock at a certain price on a specified date. This means option must always be priced less than the present value of the strike price. It can never be more than the strike price, otherwise an arbitrageur can make risk-less profit.
We can long (buy) or short (sell) a call or put option
What Does It Mean To Long Or Short An Option?
- Long Put: Owner of a long put option has the right to sell a stock at a fixed price.
- Long Call: Owner of a long call option has the right to buy a stock at a fixed price.
- Short Put: Owner of a short put option has received the premium therefore he/she is now obliged to buy the stock.
- Short Call: Owner of a short call option has received the premium therefore he/she is now obliged to sell the stock.
Each of these types have their own pay off profiles and usages.
What Are Option Attributes?
An option contract has a number of attributes. These attributes include maturity date, strike price, stock price etc. I will be providing an overview of common option attributes in this section:
- Premium: Option holder has to pay premium (money) to buy or sell an option. Premium is lost if the option is not exercised.
2. Maturity date: Also known as its exercise date. Time to maturity is the difference in days between today and the maturity date. This is the date when option needs to be exercised. Options with longer time to maturity increases the chances of earning more money. However, when you are deep in the money and own put option then increasing time to maturity can have a negative effect on your put option.
3. Strike Price: Each option also has a strike price. This is the agreed future price to buy the underlying asset. Strike Price (K) is the price at which holder can buy the underlying asset (if it is a call option) or sell the underlying asset (if it is a put option). It also known as exercise price.
4. Dividends: Underlying assets can also pay dividends. V
5. Volatility: Measures how an assets will move in the future. It is expressed on an annual basis in percentage. Higher the volatility, more the asset price moves. High volatility is good for option holders because there is a higher probability of gaining higher returns for options that are based on assets with higher volatility.
6. Current Asset Price: This is the current price of the asset underlying the option.
7. Interest Rate : Risk free interest rate
Price of an option is dependent on these attributes
What Are The Common Option Types?
There are a number of option types. Most common option styles are:
- European: These options can only be exercised at exercise date.
- American: These options can be exercised at any time before exercise date.
- Bermudan: These options can only be exercised at predetermined dates before exercise date.
Let’s Combine All Concepts: Option Attributes And Price
The table below illustrates how option factors impact its price:
For instance, for call option, increase in underlying’s price increases option’s price. Furthermore, for put option, increase in underlying’s price decreases option’s price.
Dividends always reduce stock’s price and thus reduction in stock price decreases call option price and increases put option’s price.
We have learnt a large number of concepts above. Let me summarise it
The image below illustrates four types of options positions and their characteristics:
Payoff of an option is dependent on whether an option is a put or a call option. If we draw the pay-off profiles where x-axis is the stock price and y-axis is the profit, we can see that shorting an option has mirror image on x-axis of longing an option.
These profiles are known as hockey sticks:
- For a long call option, owner of the option has the right to buy a stock at a fixed price. The fixed price is also known as strike price. Therefore the owner benefits when underlying’s stock price increases above option’s strike price. It also implies that the maximum profit is unlimited. However, in the worst case scenario, if the stock price falls below the pre-agreed strike price, then on the exercise date, owner of the option can opt out and decide not to buy the underlying asset. As a result, the premium paid to get the option is lost. Therefore the maximum loss for a long call option is the premium that the owner paid.
- For a short call option, a premium is received. Consequently, owner of a short call option has the obligation to sell the stock regardless of what the stock price is on the exercise date. If the counterparty decides not to buy the asset then the premium becomes the profit. Therefore the maximum gain is the premium however the loss can be unlimited.
- For a long put option, owner of the option has the right to sell a stock at a fixed price. The fixed price is also known as strike price. Therefore the owner benefits when underlying’s stock price remains below option’s strike price. If the stock price increases above the pre-agreed strike price, owner of the option can opt out and decide not to sell the underlying asset. As a result, the premium received to sell the option is lost. It also implies that although the maximum profit is unlimited, maximum loss is the premium received.
- For a short put option, owner of the option has received the premium to sell the option for a strike price. Owner of the option has the obligation to buy the stock. Owner benefits when the stock price rises. In the best case scenario, if the underlying asset’s price rises above the strike price then the owner will keep the premium as profit. Therefore the maximum gain is the premium however the loss can be unlimited.
Option Pay-Off Calculations
To further explain the concept above, the table below is created to explain how we calculate pay offs of put and call options.
For example, let’s assume that an investor pays £100 premium to buy an option with a strike price of £3000. Let’s analyse how stock price impacts the profit:
We can see that call option holder benefits when stock price increases and put option holder benefits when stock price decreases. Option holder limits the loss by the premium amount.
A Fundamental Concept: Put Call Parity
Lastly, I wanted to outline one of the most fundamental relationship between put and call option. Put call parity is a very important concept of options. It can help us understand relationship between put and call options better. Furthermore, it introduces the concept of portfolio replication — how we different transactions can be combined to yield same results.
Put Call Parity Rule States:
Two portfolios are considered equivalent if they have equal payoffs.
Put call parity illustrates that if you have two portfolios where:
- Portfolio 1 consists of an European call option and cash of K amount.
- Portfolio 2 has a European put option and a stock
- Both put and call options need to be based on same asset, have the same strike price and time to maturity. Cash in portfolio 1 is the same amount as the strike price of both call and put options.
Then both portfolios are identical because they will generate identical pay-offs and cashflows. The portfolios will have identical payoffs regardless of how ever stock price moves.
Price of Call Option + Strike Price x exponential ^(-rate x time to expiration) =Price of Put Option + Stock Price
The equation above is stating that a long position in a stock along with a long position in a put option is equal to a long position in a call plus present value of cash (which is Strike Price x exponential ^(-rate x time to expiration)).
Cash could also be replaced with a bond that discounted continuously at rate r and has a face value of K pounds.
This article introduced options by first explaining what options are, then it outlined their common types and attributes and finally, it explained put call parity.
If you want to start from the basics of derivatives then have a look at my article “What Are Derivative Products?”.
Please let me know if you have any feedback.
QYLD’s Covered Call Options, Explained
The Global X Nasdaq 100 Covered Call ETF (QYLD) is designed to offer investors with potential monthly income while seeking to lower the risks of investing in a major US index through a strategy that writes monthly covered call options on the Nasdaq 100 Index.
QYLD’s covered call position is created by buying (or owning) the stocks in the Nasdaq 100 Index (NDX) and selling a monthly at-the-money index call option. An option is a contract sold by one party to another that gives the buyer the right, but not the obligation, to buy (call) or sell (put) a stock at an agreed upon price (strike price) within a certain period or on a specific date. In return for the sale of the call option, the fund receives a premium, which can potentially provide income in sideways markets and limited protection in declining markets. However, the fund gives up that profit potential if the index rises above the strike price of the index call option.
QYLD’s Covered Call-Writing Process:
- QYLD buys all the equities in the Nasdaq 100 Index
- QYLD then sells Nasdaq 100 Index options (NDX) to a counterparty that will expire in one month
- A premium is received in exchange for the sale of the index options
- At the end of the month, QYLD seeks to distribute a portion of the income from writing/selling the NDX index option to the ETF shareholders
- At the beginning of each new month this process is repeated
Index Options Basics
- Expire at the end of the month
- Unlike single stock options that can be exercised at any time, index options cannot be called/exercised early
- Settle in cash, not in delivering the underlying index holdings
- Higher index volatility can lead to larger premiums
- If there are gains from writing calls, they are taxed at 60% long term capital gains rates and 40% short term capital gains
Since the index options cannot be called early, it only matters where the index finishes for the month. Prior to expiration, all market swings that take place throughout the month don’t matter.
Down Market: In the illustrative example below, the Nasdaq 100 index ended the month below the strike price. So, QYLD which sold the call option would potentially benefit from the premium received. This may offset some or all of the decline in the underlying equity holdings.
Flat Market: If the index price has not changed at the end of the month, QYLD keeps the money it collected from selling the monthly index call and the Fund still owns the underlying equities.
Up market: If the index price rises at the end of the month, potential gain will be limited since the Fund sold a call option at a predefined strike price. As the index rises above the strike price, the Fund still keeps the money collected from selling the monthly index call option, but won’t benefit from the entire increase in the index value.
QYLD has historically distributed a high level of income to investors
PREVIOUS 12 MONTH DISTRIBUTIONS
QYLD has provided a Measure of Protection
QYLD performed better than the Nasdaq 100 index during certain downtrends.
Source: Bloomberg, between March 5, 2020 and December 20, 2020. The rates of return shown are represented by NAV returns not intended to reflect future values of the ETF or the index or future returns on investment in the ETF. Performance data quoted represents past performance and is no guarantee of future results. Current performance may be lower or higher than the performance data quoted. Investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than the original cost. See QYLD’s Fund Page to find the most recent month- and quarter-end performance numbers. Portions of the distribution may include a return of capital. These do not imply rates for any future distributions. The ETF is not required to make distributions. Nasdaq 100 is QYLD’s broad market benchmark.
QYLD: The Global X Nasdaq 100 Covered Call ETF follows a “buy-write” (also called a covered call) investment strategy in which the Fund buys a stock or a basket of stocks, and also writes (or sells) call options that correspond to the stock or basket of stocks. The Fund uses this strategy in an attempt to enhance its portfolio’s risk-adjusted returns, reduce its volatility, and generate monthly income from the premiums received from writing the call options.
Authored by: Rohan Reddy
Dec 24, 2020
Introducing the Russell 2000 Covered Call ETF (RYLD)
Investing During Volatile Periods
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SEI Investments Distribution Co. (1 Freedom Valley Drive, Oaks, PA, 19456) is the distributor for the Global X Funds.
Check the background of SIDCO and Global X’s Registered Representatives on FINRA’s BrokerCheck
There are risks involved with investing, including possible loss of principal. Concentration in a particular industry or sector will subject QYLD to loss due to adverse occurrences that may affect that industry or sector. Investors in the fund should be willing to accept a high degree of volatility in the price of the fund’s shares and the possibility of significant losses.
QYLD engages in options trading. An option is a contract sold by one party to another that gives the buyer the right, but not the obligation, to buy (call) or sell (put) a stock at an agreed upon price within a certain period or on a specific date. A covered call option involves holding a long position in a particular asset, in this case U.S. common equities, and writing a call option on that same asset with the goal of realizing additional income from the option premium. QYLD writes covered call index options on the Nasdaq 100 Index. By selling covered call options, the fund limits its opportunity to profit from an increase in the price of the underlying index above the exercise price, but continues to bear the risk of a decline in the index. A liquid market may not exist for options held by the fund. While the fund receives premiums for writing the call options, the price it realizes from the exercise of an option could be substantially below the indices current market price. QYLD is non-diversified.
Shares of ETFs are bought and sold at market price (not NAV) and are not individually redeemed from the Fund. Brokerage commissions will reduce returns. Global X NAVs are calculated using prices as of 4:00 PM Eastern Time. The closing price is the Mid-Point between the Bid and Ask price as of the close of exchange. Closing price returns do not represent the returns you would receive if you traded shares at other times. Indices are unmanaged and do not include the effect of fees, expenses or sales charges. One cannot invest directly in an index.
Carefully consider the Funds’ investment objectives, risk factors, charges, and expenses before investing. This and additional information can be found in the Funds’ summary and full prospectuses, which may be obtained by calling 1-888-GX-FUND-1 (1-888-493-8631), or by visiting http://www.globalxetfs.com/. Read the prospectus carefully before investing.
Global X Management Company LLC serves as an advisor to Global X Funds. The Funds are distributed by SEI Investments Distribution Co. (SIDCO), which is not affiliated with Global X Management Company LLC. Global X Funds are not sponsored, endorsed, issued, sold or promoted by CBOE, nor does CBOE make any representations regarding the advisability of investing in the Global X Funds. Neither SIDCO nor Global X is affiliated with CBOE.
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