How to Pick the Right Stock Options (Part II)

You’ll often see options described as having both ‘limited risk’ and ‘unlimited reward’. It’s these two characteristics that are often used to promote buying options.

Limited risk, because the most an option buyer can lose is the premium they pay. And unlimited reward, because, technically, a share price could go to infinity, so the buyer of a call option could theoretically make untold gains.

But, as I wrote last week, it’s much harder to make money from buying options than it looks. Sure, a share-price rally could enable you to profit when you buy a call option. But there are two hurdles you need to overcome for the trade to be profitable.

First, the share price has to rally above the option strike price, plus the premium you paid for buying the option.

If you take a look at the following table, you’ll see what I mean. The option is for AMP Ltd [ASX:AMP] and has a May expiry — about 11 weeks away from time of writing. I’ve put a red box around a call option with a $5 strike price.

AMP — May expiry


Source:CommSec
[Click to enlarge]

You can see that the option is bid (the buyer) at 14 cents and offered (the seller) at 17.5 cents. With AMP trading at $4.93 at time of writing, this option would likely trade through at around 15 cents. Meaning that the share price would need to get to $5.15 before the call-option buyer makes any money. That is, the strike price ($5), plus the cost of the option premium (15 cents).

If the share price rallied to, say, $5.30 before the option expires in May, the call-option buyer would come out in front. If, however, the share price is $5.14 or below at expiry, buying the option won’t have paid off.

Then there’s another hurdle…time. For the option to have any value, it needs to reach the breakeven point — in this case $5.15 — before the option expires. Each day, the option loses time value as it gets closer to expiry.

It’s these two things — the higher payoff (strike price plus premium) and time — that conspire to make buying options difficult to do profitably. And it’s why professional options traders look to take the other side of the trade. That is, to write (sell) options, which is a core part of our strategy at my options advisory service, Options Trader.

Price and time

Just as you need to be aware of both the payoff level and time factor when you buy an option, the same applies to writing options — where you don’t want the share price to be at expiry is when it’s above the option’s strike price.

Writing a call option comes with obligations. If the buyer exercises the option, the option writer has to hand over the shares at the strike price. If the share price is trading at $5.30 when the option expires — like in the AMP example above — writing a $5 call option obligates the option writer to hand over the shares at $5.

That means they’ve given up 30 cents in profit, minus the 15 cents they received for selling the option…a 15 cent loss all up before brokerage.

Unlike buying a call option, writing a call option comes with a ‘limited’ profit. The premium you earn for writing the option is the most you can make out of the trade.

Writing a call option when you don’t own the underlying shares can lead to unlimited losses, given that (as I wrote above) shares technically can go to infinity. So you only ever write call options over shares you actually own.

So, why would you consider writing call options?

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It’s all about income

The primary aim of writing a call option is to generate income. And, as we’ve discussed, the aim is for your option not to be exercised. We want the option to expire without being exercised so that we can repeat the process over again.

To save you scrolling back up, let’s take another look at the table for AMP.

AMP — May expiry


Source:CommSec
[Click to enlarge]

We’ve already taken a look at the $5 call option. If you look further down the table, you’ll see a call option with a $5.25 strike price. The higher the strike price, the less chance it has of being exercised; but, as you’d expect, the less premium you’ll receive also.

With the $5.25 call option, the premium would be around 6–7 cents. That’s about $60–70 if you wrote 10 contracts, which equates to 1,000 underlying shares.

However, if you scan upwards, you’ll see a $4.90 call option bid at 19 cents and offered at 22.5 cents. This would likely trade at around 21 cents, generating $210 (before brokerage) on 1,000 shares.

So how do you pick the strike price? The aim is to write the call option at a strike price you believe will be above the share price at expiry. You might look to write a call option after a stock has rallied (but has run out of steam).

Or you could write the option when the share price is trading sideways aimlessly, letting the time decay of the option work to your advantage. Where you wouldn’t write a call option is when you think the share price might rally strongly.

If you get it right, writing call options can be a great way to bolster your income — well beyond that available from collecting dividends. AMP’s most recent dividend was 14 cents, or $140 on 1,000 shares.

We already saw earlier that both the $5 and $4.90 call options will generate more income than this ($150 and $210 respectively). Put the two together — option premiums and dividends — and you have the potential to more than double your income from shares over the year.

Just keep in mind some key rules: Only ever write a call option at a strike price you’re prepared to hand the shares over at. And only write an option if you receive sufficient premium for doing so. There’s no point taking on an obligation for little more than pocket change.

And one more thing: Always be aware of any tax consequence should the call option be exercised. Meaning that you have to hand over (sell) your shares to the option buyer, triggering potential capital gains.

Matt Hibbard,
For The Daily Reckoning

Matt Hibbard

Matt Hibbard

Matt Hibbard is Port Phillip Publishing’s income specialist. While most investors focus on making money in the short term, Matt takes a different view. He’s focussed on how you can invest today to grow wealthy in 10 or 15 years’ time. You can find more of Matt’s work over at Total Income where he’s hunting down the next generation of companies that could pay you more each year than you initially invest.

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