Investors have more choices than simply purchasing stock, bonds or mutual funds
in today's stock market. Strategies such as buying and selling stock options can
increase returns or minimize losses.
Options are categorized into two different types, a call option and a put
option. We are going to discuss call options. A call option is defined as a
contract that gives the holder the right to buy the underlying security at a
specified price for a certain, fixed period of time.
Generally, buying one option contract gives the purchaser the right to buy 100
shares of a stock. If the stock price exceeds the intended price (known as the
strike price) the option can be exercised and profit made on the difference
between the current price and the strike price.
As long as a market exists for the option, it can be bought or sold any time
until it expires. Options not sold or exercised become worthless at expiration.
There are great brokerage firms to consider when looking for online broker, like
Scottrade Review, Optionshouse Review and
TradeKing Review.
It is possible for an investor to be either a buyer or a seller for a call
option. Selling naked calls means that an investor will sell an option without
owning stock to offset the option. This is a high risk strategy and therefore
most brokers will require substantial equity in your account before they approve
you for this strategy. If you sell a naked call, General Electric, for example
at a $15 strike price with two months left until expiration you would receive
$100. That $100 represents the option premium. We will assume that GE is trading
at $14.80 per share. If the stock stays below $15 per share you get to
keep the $100 premium which you made with no money invested because you sold a
naked call. Sounds fantastic, right? However, if stock shoots up to $40 per
share, you would be obligated to go to the market and purchase 100 shares of GE
for $4,000 and deliver it to the option holder for a loss of $2,400 ($1,500
strike price received less $4,000 cost of shares plus $100 option premium
received). I hope you can see why this strategy carries unlimited risk. I
do not recommend this strategy for new option traders.
A safer strategy is to sell covered calls, where the investor owns the
underlying stock, and sells the call option. If you had owned the GE stock in
the above example you would have simply delivered the 100 shares you already
owned to the option holder, and received the strike price of $1,500, and kept
the $100 premium.
I know what you are thinking. I just gave up all that increase in stock price by
selling GE at $15 per share instead of $40 per share. This is true. You should
never sell covered calls on stock that you want to keep. You should look at your
investment in the stock and calculate your potential gain/loss if the stock were
to get called away before you sell a covered call on those shares.
There are dozens of brokerage firms in the US and choosing the best one is not easy. Some companies are simple terrible, so
make sure to read reviews before you sign up:
Sogotrade Review,
Just2trade Review,
Wellstrade Review.
I successfully use covered calls as part of my investment strategy. Covered
calls provide a safe, reliable method for me to generate consistent returns
regardless of which direction the stock market moves. The key is knowing a
variation of this popular strategy to increase your success rate in all market
conditions.