What’s that outside your window? Wow, see that car in your driveway. It’s a real head turner! You must get a lot of compliments.
It has value to you as an asset. There’s an intrinsic value you derive from owning it. You use it for transportation. It gets you from point A to point B.
Without it you would have to walk to the grocery store, and then lug your bounty home, that’s your groceries, not the paper towels, for several blocks or miles. Anyway, that’s not cool.
What is cool is your car! You take it cross country on a family vacation like Clark Griswold. Stopping along the way at every small town with a 20-foot-high fiberglass tourist trap sculpture. “Magnificent kids, isn’t it?” You’re making memories baby! All along the way, and they’ll never forget it.
Besides functionality, it’s pretty cool car. In fact, it looks awesome, and you look cool driving it. I bet a lot of people would look cool driving it. Hey, maybe I would look cool driving it.
I wonder how much it would be worth today. What’s its market value. I wonder if it is destined to be a classic? It might be worth a fortune in the future! I wonder if I can buy the right to purchase it in the future at today’s price even it if goes up in value for a fraction of the market value today! That would be amazing.
Yeah, we got something here! Stick with me for a moment. Think about this. I’ll pay you a premium worth 2% of the cars market value for the right to buy your very cool car in the future. Here’s the deal. If the market value of your car goes up I’ll redeem my right to pay you for it at a previous lower price. Meanwhile, you get to keep using, and maintain ownership. If it doesn’t go up in value you keep the car, the money I paid for the right to buy it, and I walk away.
What do you think?
Options Trading Is Risky!
Early in my career I didn’t really understand stock options. They seemed risky. Like a get rich quick, highly speculative scheme. The kind of thing you could lose your shirt participating in. Trading options contracts was for slick wall street investors, and not for main street clients.
You too may have heard that dealing in stock options is risky, and it can be.
However, the risk associated with trading stock options may be managed. You could potentially generate consistent investment income to help pay for reoccurring retirement expenses such as Medicare or Long-Term-Care insurance premiums, and risks may be effectively managed if you stay on the seller’s side of the transaction and have ownership the stock.
Sellers and Buyers
There is a buyer and a seller in an option contract transaction. The buyer pays a premium to the seller for the right to purchase the seller’s stock within a future time frame at a set price. It’s worth repeating, “the buyer pays the seller a premium.”
The seller keeps that premium regardless of whether the stock option is exercised. Therefore, the seller receives income whether the options contract expires or is executed. This can be repeated over and again to generate income for the stock owner.
Selling Naked
Investors can get sideways when they sell stock options against stock they do not own. This is called an uncovered stock option, or a selling a “naked” option, and it is risky business. Say you sell a call option on stock that you do not own. The future stock price is such that the buyer executes the option. You must now acquire the stock to be sold to the buyer of the option. This could result in capital loss that greatly outweighs the premium you received for selling the option.
Credit Spreads
Sell a call option that gets executed and you are obligated to sell your stock. If your stock is skyward bound you may miss out on capital appreciation. This is a potential risk that must be understood.
You may cover this risk by buying an option to purchase your stock back at a further price. The premium that you sell your option for, minus the premium that you pay for the option to buy back, is called credit spread. This is real money that you put in your pocket.
Computer technology has made these transactions possible. What would’ve been extremely labor-intensive in the past is now possible to do over and over again generating revenue with much less effort.
While manually managing the sale of options contracts alongside the purchase of options contracts to protect yourself would have been a full-time job, today many firms are able to use super computers to make these transactions happen seamlessly.
Buyers Are Speculating
Buyers generally bare the risk. They’re speculating that a stock will move in a particular direction, and they’re paying for the right to buy that stock at a predetermined price in the future. If that bet doesn’t pay off, the buyer is out the premium.
Conclusion
So, can you lose your shirt trading options? You bet you can! Especially if you’re an aggressive buyer who pays premiums on bets that don’t come through, or if you’re “naked”, selling something you don’t actually own.
On the other hand, can dealing in options be a benefit to you and your portfolio? The answer maybe yes.
It is possible to increase the yield on the portfolio of stock that you own if you’re willing to sell options to buyers who are speculating on movement of your stock. Remember, as the Seller you receive a premium from the buyer. You keep it regardless of whether the buyer actually executes the stock option to purchase your stock.
Leveraging credit spreads may be an effective strategy to generate additional income to cover the routine expenses in retirement with assets you already own.
Stretch your imagination. What would you use the additional income for? How about insurance on the classic car sitting your driveway. Man… it’s a cherry ride!
“Investment Adviser Representative of and advisory services offered through Royal Fund Management, LLC, a SEC registered investment adviser.”