Options are contracts. 1 option contract represents 100 shares of stock. Like any contract, it is between 2 parties that are in agreement, and there is a mediator that charges a fee. 1 party is the buyer, the other party is the seller. So what is the buyer buying? The right – or option – to buy a stock (call) or sell a stock (put) at the agreed upon price. There are 2 sides to every coin, so simply think of the other side of the coin as the opposite thing is happening to the other person. If the buyer has the option to buy/sell the stock at an agreed upon price, then the seller has the obligation to sell/buy the stock at that price IF the contract is assigned to them. I say IF, because the contract is not going to be assigned if the contract does not benefit the buyer – the person with the options and money on the table to lose.
Options are a system of statistical probabilities. If the market feels there is a chance that something is going to happen (The stock price being higher or lower than where it is now), there is a sizeable amount of money that can be spent, or earn by signing that contract. Selling covered call options is primarily what I do and what I talk about. The further “out of the money”, or the higher the “strike price” is compared to the current stock price, decreases the probability that you will be assigned the contract, but also decreases the amount of “premium”, or money, that you collect.
You can repeat this mantra to yourself whenever you are feeling overconfident: I will not be betting on the stock moving in a certain direction. I will not think that I am smarter than the market. I will not buy options contracts (that are unhedged through more complex options trading strategies that we do not go into on this blog)!
Just like in your more familiar bets on sports games, rock-paper-scissors, or darts, you would not want to put very much money on a bet with low odds that are not in your favor, and vise-versa for the other party. The list of prices of different options for a stock is called the “option chain“. At any given time, it is unlikely for the stock price to be very different than it is right now, but it is MORE likely for it to be much different the further out in time you go. That’s why the value of the contract increases when you compare the SAME “strike price” at 30 days, compared to 60 days, compared to 90 days.
The following is an example. A buyer says, “I’ll bet $50 dollars the stock price rises from $14 to $15 within 90 days”. The seller replies, “I’ll take that bet!”. If the price is below $15 by the close of the market on the 90th day, then the seller is not obligated to sell the stock for $15 dollars. If the price is at, or above $15, the seller is obligated to sell the stock. Say this seller obtained this stock at a 10% discount for $12.60 per share. If the seller keeps 100 shares of stock that he obtained at a total price of $1,260, and the contract expires under $15, then the seller keeps his “premium” for signing the contract. In this case, $50 is almost a 4% gain on the seller’s cost of $1,260 for entering this 90 day commitment. If the price is above $15 at the contract expiration date then he keeps his original $50 for signing the contract. In addition, the seller must sell the stock at the agreed upon $15 per share. In this example the seller made a $290 profit, or 23% on the total cost basis.
These are hypothetical numbers, but they are realistic! This is why I much prefer selling covered calls on my stock with the goal of selling the stock, instead of setting limit orders or market orders
There are many reasons why people enter options contracts. The most risky reason is to leverage their money. The least risky reason is to hedge their losses. Selling a call option is a form of hedging your losses because you took in a premium that protects you from a stock downturn. What you give up in exchange for this hedge is missing out on potential upside profit because selling at $15 is required even if the stock went to $16.
In conclusion, my philosophy is to create a win-win scenario for myself; If my ESPP stock does not sell, I am happy because I keep my premium. If my stock does sell, I am still happy because I have made an excellent ROI, and with this profit plus the initial investment I can churn it back through my ESPP or diversify.
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