I'd previously talked about how writing (selling) covered calls could be a way to help increase your income, while still owning your shares. I've also covered how it's important to understand the motivation of the other party when placing a trade.
So why would someone want to pay your money to potentially not buy your shares off you? It turns out many people in the tech industry at least are somewhat familiar with this approach, but they've only been exposed to it via a program offered by their employment or as part of their remuneration. Let's run through a hypothetical situation with a public company.
Catching a runaway train
To continue on with our previous example using AAPL (now trading at $487), they're due to unveil a bunch of new toys this week. A new iPhone (or two), maybe a watch, who knows maybe the much talked about but ever elusive TV will finally launch. It could be a pretty crazy ride if all that happens, unfortunately I'm a bit strapped for cash and I'll miss out. And if it takes off, well there's almost no chance I could afford to buy it in a month.
What if I knew there was some magical windfall of cash coming within the next 2 months. Maybe an annual bonus, or a trip to Vegas. If only I could get Tim Cook to delay the announcements for 2 months, or at least lock in today's price. Well it turns out you can lock in a price. The following are the strike prices and premiums for AAPL options that expire 4th October 2013:
- $495.00 at $14.15
- $500.00 at $12.10
- $505.00 at $10.35
So we've got the fares, now how do we catch this train?
How do you buy your seat?
Now it's a question of trying to gauge how much movement you expect, how much risk you want to stomach, and how much profit you're willing to sacrifice. We might think that all this hype is already built in to the current price, and it's only going to go higher on good news and anything less will send it back south. We could buy the $495 strike: 1 option contract buys us the right (not the obligation) to purchase 100 share on of before October 4th, for $1,415 (1 contract x 100 shares x $14.15 premium = $1,415). That's $1,415 out of pocket now, and in a month if AAPL has sky-rocketed we've locked in a price of $495 and can bank an immediate profit.
That's a decent chunk of money though, maybe we don't want to be risk so much money upfront, and want to make sure the stock is really stretching towards new highs then we might consider the $505 strike. 1 option contract at $10.35 will cost $1,035 (1 contract x 100 shares x $10.35 premium = $1,035).
It's not always sunny in Moscone
All this sounds great if you're willing to assume the only direction AAPL stock can is up. If the announcements disappoint, then the stock could crash down. And the >$1,000 you spent to buy the options will most likely expire worthless. Keep in mind though these numbers are pretty large in part because of the already high price of AAPL stock, if you exercise these options you'll have to spend almost $50k to buy the stock.
Meanwhile if you had the money to buy the stock today and the share price too a dive, it'd only need to drop 3% for you to lose the same amount of money. The difference is you'd still own the stock, whereas the options would have expired and you have nothing. Either way you've still lost, it's just one loss is more difficult to stomach than the other.