Making Money Tristan on 06 Jan 2009 01:15 pm
Options Trading Explained
I have always been fascinated by the share options, ever since I studied them during my degree in accountancy. As in most academic studies, we were taught the various methods for determining option pricing (Black Scholes springs to memory), the difference between put options and call options, and when each type should be used.
The part I never really understood, was if you buy an option to hedge your position, surely then someone else has to sell the other position, which implies they leave their position exposed. Now since then, I have gone onto do my own studying and learnt a bit more about this subject (but am by no means an expert). Principally, I was first introduced to the concept of writing options by Robert Kiyosaki’s Rich Dad’s Retire Young, Retire Rich book.
In his book, he explains how he is able to write options on stock that he does not hold, making a nice quarterly passive income. He also goes on to explain that this is not risky because the options he was writing, were for stock of a company he wanted to own anyway, and that the profit he makes from writing the options for the previous quarters would be used to acquire the stock in the event of the options excercised by the owner of the options.
I have come to learn that this strategy is called a buy-write, because the writer is obligated to buy the stock at the strike price, if the option is excercised. The opposite of this is a covered-call, whereby the writer of the option already owns the underlying stock, and is writing a call option to sell the stock at the strike price should the option be excercised.
So how could these strategies be used to make money, and what risks are attached to each strategy?
Buy Write Strategy and Risks
To make money using the buy-write strategy, it seems you have to agree to buy up shares of a company you want to own anyway, and then make money from selling your obligation to buy the shares at the strike price.
The risks with this strategy are that you could be obligated to buy shares in a company whose share value is taking a nose-dive. So for example, you may be obligated to buy 10,000 shares in a company that normally trades at £10, but your option is excercised when the share price hits £9, meaning you need to stump up £90,000 to meet your obligation under the contract. Now if the shares plummet to say £2 (as some UK bank shares did last year), you could be £70,000 down on the transaction (of course you could hang onto the shares and hope for them to recover).
Covered Call Strategy and Risks
This is where you agree to sell shares that you already own, at the strike price, to the owner of the call option you wrote. Sounds simple enough. If you own the shares already, and are happy with them, it may seem stupid to sell them, however, this is a strategy for increasing the returns on your existing shares, by making extra money by writing the call options.
For example, if you owned the same 10,000 shares that are currently worth £10 a share, and you were able to sell a call option for 10,000 shares at a cost of £5,000 each quarter, then you are making passive income (assuming the option is not excercised) of £20,000 a year. This is over and above any dividend income you may be receiving from the shares as well.
The risks with this strategy are that your shares my drop in value, but that is a risk with holding onto any shares, so is not confined to this strategy. The risk that is inherent in this strategy is the opportunity cost associated with being obligated to sell a share that is sky-rocketing.
For example, if you own 10,000 shares which are currently worth £1 a share. On the back of some good news about the company, the share price quadruples to £4 a share. If you weren’t obligated to sell the shares under the option contract, you could have hung on and sold for £3 a share profit, but instead, may have to sell at £1.50 (for example), thus the contract has an opportunity cost of £2.50 / share in this instance.
Hopefully this rudimentary explanation of how options trading from the point of view of writing the options, rather than simply buying and selling them offers an insight into how to make extra money from existing shares, and also how to earn money without even owning the shares. I don’t profess to be an expert in options trading, but found this option traders journal website to be very useful.
