Passive Pursuit of Income Blog

Thanks for visiting my post on stock options and option trading. Here, we will discuss strategies for safely making money monthly by trading stock options. I think you will find that these approaches can be successfully employed by almost anyone, so if you have good fortune using these methods please feel free to comment to that effect. (And if you want to be a little conservative, you can always focus a portion of your efforts on Getting Rich with Dividends.)

An Introduction to Options and Option Trading

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The notion of trading options often tends to make the average investor nervous. Many consider options as belonging to a vague and nebulous world that is far different from the investment environment they’re accustomed to. In a certain sense that is true; it is different from investing in the ordinary sense, but there’s nothing marticularly mysterious about stock options, as you shall soon see.

Most investors have a good understanding of the stock market as a place to buy and sell shares of publicly traded companies. (The term “share” refers to a unit of ownership in a company.) However, there are other various other financial instruments that are also traded daily, including options.

In a general business sense, an option typically refers to the right to buy some item at a designated price. For example, you may be interested in buying a car for $10,000 but want some time to think it over. In that scenario, you may be able to give the seller some amount of money – maybe $100 – to take the vehicle off the market while you mull it over. Basically, you’re paying $100 for the option of buying the car. (In other words, you’re not required to buy the car; you have the option of simply walking away.) However, whether you buy the cart or not, the seller keeps the money you paid for the option. This is essentially the manner in which stock options operate.

In terms of the stock market, an option is a right to buy or sell a specific stock at a particular price (known as the “strike price”) within a certain period of time. An option that bestows a right to buy is known as a “call”; an option that grants a right to sell is known as a “put.” However, while stocks can be bought and held forever, options will always have an expiration date – normally the 3rd Friday of a particular month – meaning that the person buying the option has a limited time frame in which to make his option trade profitable. Moreover, options are only sold in units dubbed “contracts”; a contract represents 100 shares of stock. Finally, options trade at their own price level, separate and apart from the price of the underlying stock they represent. By way of example, here is how we might conduct an option trade:

An Example of Buying a Call Option

Assume that Microsoft stock is currently selling for $23. You could buy a call for this stock, offering to buy it at a strike price of $25, with the call expiring next month. In essence, in this example, the buyer of the option would have the right to buy Microsoft stock at the price of $25 per share any time between now and next month (or to be more precise, the third Friday next month). If the price of the call is currently $1 (remember, the stock price and the option price are two separate things), the purchaser could buy one contract – representing 100 shares of stock – for $100. (The call price represents the cost of the call for each individual share of stock in the contract. Thus, the cost of a single contract would be $100, 4 contracts would cost $400, and so on.) If the call buyer chooses to purchase the stock, he will “exercise” the option. However, the buyer can also choose to just sell the option on the open market if he so desires.

This, in general, is the gist of how the trading of stock options occurs. In the discussions below, we’ll touch on several methods of earning monthly income by tradig stock options However, it should be made clear that while there is the potential for tremendous profit in option trading, not all option strategies are the same. Some are more risky than others, and if you are not careful you can suffer substantial losses. Here we will focus on what are generally considered to be more conservative option strategies.

Make Easy Money Selling Covered Calls

In investing circles, stocks and bonds are probably the best-known investment vehicles. While I am a firm believer in stock ownership as a means of accumulating wealth, I think there are some additional strategies you can use to boost your returns significantly with a minimal amount of risk. One of these strategies is the selling of covered call options.

As already noted, a call represents the right to purchase a specific stock at a designated price (the “strike price”) within a certain period of time. You can actually buy or sell calls. In fact, selling calls can be quite lucrative.

When you sell a call, you are agreeing to sell stock to someone at a certain price. If you already own the stock in question, then the term “covered call” is used to describe the option you sold; it’s considered “covered” because the underlying stock is already owned by you. Therefore, you will not need to buy any shares of the stock it in order to make good on the sale, if necessary. (By contrast, it’s considered to be a “naked” call if you don’t own the underlying stock. I would personally do not advocate the sale of naked calls, as it can leave you open to substantial liability.) Here’s how the sale of a covered call would work:

Let’s assume you currently own 100 shares of Microsoft, which at present is trading at $23 per share. You think that’s a good price and would willing sell at this point, but there’s some easy money to be had here. A glance at next month’s options reveals that the $23 call for Microsoft is currently selling for $1. That being the case, you could sell one contract of next month’s calls and earn an extra $100 on your Microsoft shares – assuming the price of the shares stays above the strike price of $23. In short, the call buyer will exercise his option and buy your shares if the price is above $23. (Why would the buyer do this? Because, if the stock price is above $23, he can buy your shares at that price – the $23 price you agreed to sell them for – and immediately sell them for a profit on the open market!) If the share price is lower than $23, you keep the $100 you earned selling the call, and you still own your Microsoft stock. (The buyer won’t exercise his option if the stock price is below the $23 strike price. Why should he pay you $23 per share when the stock is trading for less than that in the marketplace?) Basically, if you end up keeping your stock in stead of selling it, that’s a good thing because it just means that you can do the whole thing again next month – and the next month, and the next month – until you actually sell). You can use this strategy even if you don’t really want to sell your shares of a particular stock, as long as you understand that such a sale could still occur.

In short, while I’m not in a position to cover every scenario that might result from selling call options, it should be clear how selling covered calls can produce some healthy supplemental income every month. (Imagine, for instance, having 200 shares of Microsoft; or 800; or 1000.) Of course, my example here assumes that you own enough shares of stock in a particular company to start with – namely, 100 (so you can sell at least one contract). Moreover, you have to accept the fact that engaging in this strategy may require you to sell your stock, and in agreeing to sell at a designated price you may miss out on certain gains in the stock’s value. Therefore, I encourage you to read and review the subject matter carefully prior to pursuing any options strategy, including the sale of covered calls (which is generally hailed as one of the safer, more conservative options strategies).

Earning Extra Money Buying Put Options

There often seems to be very little that is rational about the stock market. Prices will rise when a company delivers bad news (because the news wasn’t as bad as the experts thought it would be), and plummet on good news (the news wasn’t as good as it should have been). It’s insane, and can make you want to pull your hair out at the roots..

However, you can sometimes use this insanity to your profit through the use of stock options – specifically, through the purchase of puts.

As previously noted, a put grants the right to sell a stock at a certain price. Just like calls, one can buy and sell put options. In fact, puts are often used by the owners of stock to lock in their profits. In essence, purchasing put options is the equivalent of buying protection for the stock owner with respect to the stock price – hence the term “protective puts”. Here’s an example:

Let’s assume that Microsoft stock is currently trading at $23 per share. Moreover, over the last two months, the price has fluctuated wildly, going as low as $15 and as high as $30. As the owner of 100 shares of Micrsoft, you’ve grown tired of the seesawing price and want to sell within the next 60 days; ideally, you’d like to hold on to the stock to see if it will go any higher, but you also don’t like the idea of selling for less than $20 per share. Knowing a little something about options, you realize that purchasing a put will guarantee you the right to sell your stock at a designated price, no matter what the stock is actually trading for. With that in mind, you look at put options that will be expiring in two months and note that for Microsoft a put with a $20 strike price costs $1.00. You buy one put contract at the $20 strike price for a cost of $100. You can now afford to wait and see if the stock price goes higher, knowing that regardless of anything else you will be able to sell your stock for at least $20 per share.

In essence, this is how puts generally work, although there are various factors to this equation that we did not address. (For example, the value of the put that was purchased will also change, such that the buyer might even be able to sell the put option itself for a healthy profit.) However, as already noted, options really are a different breed of animal than stocks, and would behoove you to research any option strategy you consider very thoroughly before investing or trading in such.

Using Put Options to Buy Stocks for Cheap Prices

Making money in the stock market is a tough proposition in this day and age. The global financial crisis seems to continue unabated; as soon as one financial fire is put out somewhere in the world, it seems that another one starts. Still, there are ways to continue to profit and garner income for yourself. One way to do this is by selling puts.

As previously discussed, a put represents the right to sell a stock at a specific price. It is possible to both buy and sell puts. With respect to selling puts, this can be used as a method of buying stocks at cheap or reasonable prices. What follows is an example of how this works:

Assume Microsoft’s stock is presently trading at $23 per share. You use Microsoft products every day and are considering purchasing 100 shares of stock in the company, but you’re livid at the thought of paying more than $20 per share.Knowing a little something about options, you understand that you can sell a put option, which may require that you buy shares of the stock at a certain price, irrespective of what the stock is actually trading for on the open market. Keeping that in mind, you peruse next month’s options (which will expire on the third Friday of the month) and quickly note that for Microsoft a put with a $20 strike price costs $1.50. Selling one contract at the $20 strike price, you pocket $150. You are now obligated to buy 100 shares of Microsoft stock for $20 per share.

Fortunately, this purchase obligation is only triggered if the price of Microsoft’s stock falls to $20 or lower. The reason? The buyer of the put option has the right to sell you his Microsoft stock for $20, but would he really do that if the market price is higher than that – maybe $22.50 per share? He’d make more money selling on the open market in that example. There’s no benefit in selling to you unless the market price drops below $20, because he can then sell his Microsoft stock to you for more than they’re valued at by the stock market. On your part, you would get to purchase the desired stock at the requested price of $20 per share. In addition, you keep the $150 that came your way by virtue of selling the put, thereby making your effective purchase price was $18.50 per share! And if the price never gets down to $20 or lower before the option expires, you keep the $150 and can do the same thing month after month until you finally get the stock at the price you want.

In retrospect, selling puts will either let you buy stocks cheaply, or allow you to earn a little extra money every month until the stock price gets back into a range where you’re comfortable purchasing it. As always, should you see the merit in or benefits of option trading, please take the time to research stock options and option trading very thoroughly and make sure you’re comfortable in doing so before making any type of investment.

Summary of Making Money with Stock Options

In brief, options can be used as a cheap way of controlling large amounts of stock. It is not without risk, but it can be extremely lucrative and a way to earn great supplemental income on a monthly basis.

(And if you found this post useful, informative or entertaining, you may also want to visit Everyday Millionaires: How Ordinary People Got Rich and You Can, Too.)