Stock Options, Strategies & Exits
Stock options are derivative securities that give the holder the right to buy or sell the underlying stock at a set price, called the exercise price, for a fixed period. There are developed strategies using options for both conservative and aggressive investors. Different option strategies will provide profits in rising, falling or neutral markets. The beginning option investor needs to do her homework and pick strategies that fit her investment goals.
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Analyzing Strategies
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Option prices are a function of the exercise price in relation to the current value of the underlying stock, the time until expiration and the volatility of the price of the underlying. Initial option strategy analysis is the determination of the maximum gain and maximum loss the strategy can provide. The next step is to determine if the probability of the future price movement will put the strategy in a profitable position. Often different strategies are compared for the same underlying stock or the same strategy is tested on several stocks to determine which provides the most attractive profit potential.
Covered Calls
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Covered call writing is popular with conservative, income-oriented investors. The strategy consists of buying a position in a stock and simultaneously writing or selling a call option on the stock. Example: Aircastle Ltd., symbol AYR, is selling for $9.85 per share and the out $10 call option expiring in two months is selling for 60 cents. You can buy 100 shares of AYR for $985 and sell one AYR $10 call for $60 for a net cost of $925. If AYR is above $10 when the call option expires, the option will be exercised and you will receive $1,000 for the 100 shares of AYR and keep the $60 in option premium. Maximum return is $75 or 8 percent in two months. The return if AYR is unchanged is 6.5 percent, the $60 call premium dividend by the initial investment. Maximum loss if 100 percent if AYR goes bankrupt.
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Long Calls or Puts
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You can purchase or go long call options if you believe the underlying stock will increase in value. Put options are purchased to profit if the underlying stock falls in value. Options are "in-the-money" if the underlying stock price is above the exercise price for call options or below the exercise price for put options. If the underlying security price is below the exercise price for call options or above the exercise price for put options, the options are said to be "out-of-the-money." Options owners generate profits when the underlying stock moves in-the-money in relation to the exercise price. Profit potential for being long, or owning, options is unlimited and the risk is limited to the amount originally paid for the options.
Combinations
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Combination option strategies use buying and selling puts and calls of different exercise prices and expiration dates to meet a specific risk/reward profile. Combination strategies are used to profit from specific expected price movements of the underlying stock or to reduce the risk or cost of purely long or short option positions.
Considerations
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The effect of broker commissions must be accounted for when calculating possible returns of different option strategies. Commissions and bid/ask spreads can have a significant impact on final profitability.
Some option strategies are entered with an account credit and profit if the options expire without value. Others need to be closed by selling or buying back positions when the desired profit is achieved. Writing options, or going short, makes the option seller subject to exercise if the contract is in-the-money. Long contracts that are in-the-money at expiration with be automatically exercised. If this is not a desired outcome, long contracts should be sold before the expiration date.
The prices of the underlying stock and held options should be regularly monitored. Close out option positions if the maximum or desired profit position is reached. Be ready to quickly exit a position if the underlying stock moves in the wrong direction.
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