Why Options Trading?
In simple words, options contracts give buyers the right to buy or sell an equity at a pre-decided price and date. However, they are not obligated to do so. Well, what does that mean? Let’s break it down further. Imagine there is a stock currently trading at $100 per share. I can go ahead and purchase an options contract that allows me to buy that stock for $110 per share in a week from now. This is considered a ‘call option,’ an option that gives me the right (I’m not obligated to) purchase a stock in the future.
Now the question is, why would I want the right to buy a stock in the future? There are many reasons for doing so but the simple answer would be less initial investment than buying the stock outright. If I go down the typical route and decide to purchase the stock outright, I’d need to put down $100.
On the other hand, with an options contract, I only need to pay the premium and if my predictions are right, I pocket the difference in a week. For instance, if I buy the contract for $2 and in a week, the stock goes up to $115, I still own the right to buy it at $110. So I’d be able to execute my option and pocket the $5 difference ($115-$110). And, I only had to invest $2 to make the bet! I think we are all starting to see the bigger picture now.
Covered Calls
Let’s say that I own 10 shares of a particular stock which is currently priced at $100. (Note: Options are always 100 shares per contract, but for convenience, I’m using a smaller number). If I want, I can sell a call option contract at the strike price of $110 to someone else for $20 (10 shares x $2). Since I own the shares to back up this contract, it’s referred to as a ‘covered call’.
Now you might be asking yourself, what happens in a week if the stock drops? Like any other business deal, you are either going to lose or make money. So let’s discuss the two scenarios;
Stock Goes Up In Price and Buyer Executes Option
If the stock goes up to $115 in a week and the buyer executes their option, I will collect $1000 from them but I’d also owe them shares at $110. And, since I own the 10 shares in question, I can simply sell them to the buyer. But, remember when I initially sold the contract, it was at $100, so selling it at $110 is still profitable for me.
Stock Remains at $100 and the Contract Expires
This is where things get interesting. So if the price of the stock doesn’t move in a week, the contract will expire worthless. But there is more to it. I get to keep my shares and pocket the premium for the contract, too. This is how investors make money with options trading.
Pros and Cons of Selling Covered Calls
Pros
Cons
Hope this helps. Happy investing!