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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