Vol #2: Four basic strategies for Stock Option

How we come out with four basic strategies?


Well.. there's two, Call and Puts option. And when you buy something, you must have someone selling it. There's how option is created anyway. With four combination this create the base four strategies.

For every buy of Option, there must be someone else selling the Option.
For every investor who obtains a right, the other side someone must assume an obligation.

Seller = Writer : Writing a Call option is the same as issuing a call option for someone to purchase, to reduce confusion, from here onward, writing a call option means assuming obligation or issuing the call option to the market.

An Example, the buyer of an call option obtains the right to purchase 100 shares of Intel stocks @ $22 until the third Friday in May and the writer of that option assumes the obligation to sell 100 shares of Intel (NASDAQ:INTC) at that price if the buyer decides to invoke his right. This is called contingent obligation because the writer doesn't know if he needs to meet the obligation in the future. It is up to the option buyer's decision.

Summary, four options strategies:
Write Call, Buy Call options
Write Put, Buy Put options

1. Buying Call option
Bought $18.20 May GOOER.X (stock NASDAQ:GOOG @ $590)
Current Price = $593

Objective:
Bullish market (Anticipate Market is going up)
Risks:
Option purchase cost: $18.20 x 100 shares = $1820
Risk is lower than stock ( $1820 option vs $59,300 stock)
Stock must increase in price some time over the life of the option or it'll expire worthless or sold for less than the purchase price.
Not Entitled for Dividends
Gain:
Unlimited upside, if the option expires, buyer can upgrade to purchase stock and fully utilize the upside of the stock.
Break even @ Stock + option purchase price = $593 +$18.20 = $611.20

2. Buying Put option
Selling shares short means to sell the shares at $60 and when it drops to $50 buy it back to cover the shares. Never ever do short selling, cause this is how you go bankrupt and jump off a building (not all, some just runaway).
!!!! An alternative to that is to purchase a put option.
With Yahoo shares trading at $28.88, the May $28 put was offered at $2.90.
Purchasing this option gives its holder the right to sell the shares at $28 until the option's expiration date.

Objective:
Bearish market (Anticipate Market will go down)
Risks:
Put buyer can't lose more than $2.90 the premium paid.
Gain:
Every dollar the stocks drop, the Intrinsic value increases. (option value increase)
Break even @ stock - premium = $28 - $2.90 = $25.10

3. Writing Covered Calls
What's different between covered and uncovered calls.
If the option writer is in a position to fully meet the obligation then is covered call writing.
If the option writer doesn't own the stock or have money to cover it then is uncovered or naked call writing.

With Yahoo shares trading at $28.88, the May $28 Call was offered at $2.90.
Purchasing this option gives its holder the right to buy the shares at $28 until the option's expiration date.

Comparing stock holder and covered call writer

Objective:
Bullish or Stable market (Anticipate Market will stay or goes up)
Risks:
Both also bear the full downside risk of stock. However, writer receive the premium $2.90 on the next business day when he write the call option, which mean his risk is less by that amount. (Normally option is 5% of stock price so his risk is 95%)
Gain:
Bullish market for Stock holder = Winner
Market unchanged good for Covered Call Writer as he earns premium for the time.
Both gets dividend of the stock

4. Writing Covered Puts
With Yahoo shares trading at $28.88, the May $28 Put was offered at $2.90.
The writer of this option gives its buyer of the option the right to sell the shares to him at $28 until the option's expiration date.

Writer looking to add shares to his portfolio but at a lower price than current market value.

Objective:
A little Bearish market (Anticipate Market will go down a bit)
Risks:
Ownership of the stock if the stock price drop to the the targeted price. Then will have to bear with the full downside of the stock if it continues to go down.
If changes mind and don't want to purchase, you can buy a put option to counter yours before the market assigns to you.
Gain:
Stock never goes down to Targeted price : Put writer gains premium, and no stock purchase
Stock goes down to Targeted price: Put writer gets the right to buy the stock at that price with the premium as a subsidy.

Key take away for this post covered the risk, gain and objective of the buy/write of calls and puts.

Stay tune for next Volume on Strategy with Calculation on returns....