Beachside Resident #13 Options pt. 3

In the last couple issues, we established that options are contracts to buy or sell a stock at a specific price and are good until a specified time. Because of the time deadline, the value of a contract will erode away until all time has expired. In order for the option to increase in value, the underlying stock price needs to outpace the decay. Seriously, are you still with me?

Because of this decay, I made the case to not buy options (calls or puts). Under certain conditions however, it might make sense to sell options. This is where you might want to put your tin foil hats back on. With a disciplined and focused mindset, there are two possible plays.

1) If you own stock bought for $25 per share that currently trades for $27, you could agree to sell it for $30 per share and get paid to do it. You must be indifferent to selling the stock. If it goes to $50 per share you’re still obligated to sell at $30. This is not a get rich quick scheme. It’s a way to generate a little income from your portfolio.
This strategy is called a Covered Call.

2) If you plan to buy XYZ stock currently trading at $25 a share, you could sell a put option that would allow the buyer of that put to sell you the stock for $24 a share. If you like the stock at $25, you should love it at $24 and get paid to buy it. The risk is if the stock tanks to $10 share, you still must pay $24 but you were going to buy it anyway, right? Your broker will require a cash balance to be held in case the option is exercised. This strategy is called a Cash Secured Put.

How can you sell options you don’t own? Think of it as selling an obligation to buy or sell. It’s very possible the option expires worthless in which case you keep the cash you were paid and do it again.

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Beachside Resident #12 Options pt. 2

Last month, we looked at options and covered the basics. Time for some fun. Grab your tinfoil hat and galoshes. We are going on a dark journey. Rarely talked about, in back alleys it’s whispered only in hushed tones…shhh…time decay.

All options have an expiration date. You have the right to exercise your option until that date. Time decay is simply time running out as that date draws near. Want a visual? Imagine a handful of sand. Imagine sand slipping through your fingers as you near the deadline.

If the option expiration is a year away, it will have a lot of time value. If it expires in two days, not so much. Options are priced to fail. Based on the volatility of the stock and the amount of time to expiration, most options whither away worthless much like the handful of sand. What this means to you is, if you buy a call option because you’re sure XYZ stock price is going to soar, that expected bump is already priced into the option.

If you’re still reading, it’s now safe to take off your hats. The bottom line is, it’s really hard to make money buying options. It’s gambling. The stock not only has to move in the direction you think but it has to outpace the time erosion. Even if you’re right, you could still lose. Visual? Think jumping in a river and trying to swim upstream.

If you read between the lines, you know where I’m going with this. If buying options is dangerous, what about selling options? There’s risk in everything. If you never trade options, that could be a good thing. However, if you do, why not let time erosion work in your favor? Think downstream.

I will soon be hosting investment seminars at the Cocoa Beach Library. Check with them for time and date.

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