Selling Options

Hello Everyone,

Thank you for all for all of the great response from my last post about options. As promised today I am going to explain to you how selling options works.

The first thing you need to know in order to understand selling options is the concept of premium. Remember in my last post when I explained that when you buy an option you have to pay for the right to buy or sell the underlying security at a future date at that specific price. That amount you pay is called premium. Selling options is also known as "writing options" or "premium harvesting".

I think that the best analogy to use to explain how selling options works is insurance. Today I am going to explain selling put options... When you buy car insurance you pay a monthly premium, and if you ever get in a car accident the insurance company pays you a lump sum to cover your costs. When you sell put options you are acting as the insurance company. Someone in the market place, we will call him Bob, believes that the market is going lower and wants to BUY a put to "insure" against the possible losses. You, as the seller, believe that the market is not going to go down, and therefore are willing to act as the "insurance" against the market going down. You are going to sell Bob a put option (his insurance against stock losses).

Let's put some numbers to this... today Google stock (GOOG) is at 679. Bob can only stand a 5% loss in one week, therefore he wants to buy a put option 5% below the current stock price with a strike of 645 (679*.95= 645). This way if Google drops more than 5% in one week the put option will pay off, protecting him against the losses. You on the other hand do not believe that Google stock will drop more than 5% in one week and are therefore willing to assume the risk on the other side of Bob's trade (act as the insurance company). You sell him the 645 one week put option on Google stock and you collect $70 in premium. As long as Google stock does not drop below 645 in one week you get to keep your $70. If the stock does drop below 645 then you must pay out the value of the put to Bob at the end of the week, which in theory could be any amount depending on how much the stock drops. Therefore in this trade I just explained you have an unlimited loss potential. However because the probably of Google stock dropping more than 5% in one week is so low, you are will to take on this risk to make your premium. This is known as high-prop trading.

One key difference between buying a put and selling a put is that when you buy an option you have the "right" or the "option" to exercise your put. When you sell an option you are obligated to deliver your pay out. Therefore in this example you could make $70 per contract in an instant as long as you think that Google stock will not drop more than 5% in one week.

I will let you think about this a little before I move on to more complex option trades, and explain to you how you can mitigate the unlimited loss potential described above.

Good bye for now,

Breana

Planet Money

Hello Everyone,

I wanted to make you aware of an amazing radio show/ podcast about finance. NPR's Planet Money has easy to understand, unique and timely shows about finance. I would highly recommend it to all. Here is the link to their website. I usually listen to it on my NPR app on my iPad.

http://www.npr.org/blogs/money/

Breana

What are Options?

Hello Everyone,

Today I would like to talk to you about options. Options are a financial instrument that are very misunderstood. This is understandable because they are very complicated and work very differently than other financial instruments. That being said, options are my new favorite way to invest and I believe are the future of investing as the technology gets better and costs to trade come down.

Options are derivative securities meaning that the price of an option is derived from the price of an underlying asset. For today's purposes we will talk about options on SPY which is the exchange traded fund (ETF) indexed to the S&P 500.

By definition an option gives you the right to buy or sell an asset at a specific price in the future. There are two types of options- puts and calls. A call option would be bought if you believe that the underlying assets will increase in value. Here's an example...

Today SPY is at 140.93. I believe that the S&P 500 is going to rise. Therefore I am gong to buy a call option on SPY with a strike of 141. Say that one week from now SPY rises to 145. I can choose to exercise the option and buy the SPY at a price of 141 and immediately sell it in the market at 145, resulting in a profit of $4 per share.

Another characteristic of options is leverage. One call option represents 100 shares of the underlying assets. Therefore in this example you have made $400 on one call option! However you did have to pay for that call. What you paid to buy the call is called premium. Today it would cost about $100 in premium to buy a one week call option at 141. Therefore you would have netted about $300, or a 300% return. Where as if you had purchased 100 SPY shares at 141 and sold at 145 you would have had to invest $14,100 instead of $100! That is the power of leverage. When you buy an option the most you can lose is the premium you paid for the option. In this example $100.

The same concept is true for a put option, only when you buy a put option you are betting that the market will go down. Using a similar example as above, today the SPY is at 140.93. You buy a put option at 141. In one week SPY drops to 137. You now have the right to borrow 100 SPY shares at 137 and sell them at 141, making $4 per share. Don't forget that you had to pay for that put option. Today it would have cost you $120 to buy the put. So, you made $400 you paid $120 and you netted $280. The most you could have lost in this trade is the $120 you paid in premium to buy the put option.

I am going to leave you to ponder the concept of buying options. I will explain selling options soon. Then we can move on to more complicated option trades such as spreads, butterflies and iron condors.

As always, I welcome all questions!

Cheers,

Breana