Buying and Selling Stocks Exploiting the Courtesy of Option Contracts
Many traders find the option trading activity a risky and unmanageable, well, it all because of lack of knowledge.
Buying and selling stocks, is surely a craft you should work on very carefully.
In my last article on buying stock at a discount, I demonstrated the power of knowing your craft with options trading.
Let's say you are in a position with long stock, and you intend to sell.
Why want you consider selling this stock with premium?
To sell stock with premium you can do it only with the stock option contract. Before we start, we need to review basic option trading terminology.
Option – a future contract that the buyer has the right but not the obligation to exercise and buy or sell the underlying asset. Basically, we will discuss the stock options.
Call option – The buyer of this contract has the right but not the obligation to buy the stock from the seller (writer) of this option.
Call at the money – The exercise price is equal to, or close to, the stock price.
Let's say if the stock price is $35.60 and the at the money' strike will be $35.00.
Time to expiration – This is the time left for this contract to exist. At this time, ether you exercise or receive money if your option is in the money it has an intrinsic value.
In the money – if the stock traded at $40.00 and your call options strike is $35.00, it means your option is $5.00 dollars in the money and you can exercise your option and get the stock worth $40.00 at the price of $35.00. Or you can sell the option before the expiration and receive the money difference.
When the stock goes down the price of the option is inflated (implied volatility rises). It means that in addition of the rise in intrinsic value of the option, it is also inflated because of uncertainty. However, there can be a behavior that when the stock rise the implied volatility (IV) rises too; it happens when the market do not agree with the stock rise and bets against it.
Trading tactics test case: (FFIV) F5 Networks, Inc. From what we see is that this company's stock rises and its IV rises also. It's insinuating that the market does not agree to its movement and because of these readings you have decided to sell the stock. One way to sell is in the market for the price it's trading now (June 24, 2008) at $29.27. The other way is to sell with premium. Call at the money strike: 30 expiration at end of July trades at $1.35. It means that if you get exercised you will sell the stock at the price of $30.00 and add the premium. If you calculate the premium in percentage points you will see about 4.5% added to your gain already you have from the stock, and if you will not get exercised still you will get to keep the premium. This strategy is called covered call.
Covered call option strategy description: This strategy is suitable for those who hold an underlying security and their outlook for the short term is neutral. It is suitable for those who want to sell their underlying security at a premium, and is suitable to hedge the underlying security position from a moderate decline.
The procedure is to acquire the underlying security and then write (selling short) an underlying call option. The gain mostly will come from the option that would lose value through time decay, and eventually if it not assigned, it will be worthless at expiration (out-of-the-money).
Before entering a trade, please check the account requirement and restrictions (see the following note).
Note
Writing (selling short) a put option requires an authorized margin account with the following restrictions: account net worth should be more than $100K, and the proper amount of money to cover probable incurred losses. A common brokerage firm calculates short-selling risks according to the financial instrument's probable volatility, called standardized stress of the underlying. For instance, for equity options, narrow based indices, single stock futures, and mutual funds the stress parameter is plus 15%, minus 15% and add the premium received. To illustrate a short put's required funds, let's take for example writing one put, strike $50.00, stock price at $48.00, 45 days to expiration.
The calculation will be as follows: the risk is on the downside, 52 X 0.85 = 40.80. Then 50 – 40.8 = 9.2 premium received 3.1, meaning the account must have funds exceeding 9.2 + 3.1 = 12.3 for every contract (more than three times the premium).
The broker monitors margin requirements in real time and will liquidate the account 10 minutes after the margin call, if there is no response fixing the margin requirements. However, a covered call position holds the required underlying to cover a rally that supposes to incur damage to the short option strategy. Also, instead of buying the stock, it is sometimes better to buy the futures contract.
About the Author: ASIO Investment Tools inc. www.analyzetrade.com Founded by veterans of the management and development of financial software systems, together with veterans in the hedge fund, portfolio, and risk management industries, ASIO Investment Tools Inc.
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