28 Oct 09 Should You Buy Or Sell Options

To buy options, or sell them?

If you are a seller of options, you have a fixed amount of income that you can collect. You will always receive this portion of the option. Now, there is another part of the option that you may or may not receive. You always receive the theta or time value. Now the rest of the option is based on what the stock does. If a $50 strike priced option expires at $49.99, you collect that entire premium. Now if you were to sell a $40 strike priced option for a $50 stock, you might receive $10.50 per share. This .50 per share is what you will always get. You will also technically get the $10 per share, but you will have your shares “called” in, and that means that you have to sell them at $40, but you keep the $10.50 so if it expired at the same price, you would only gain the $.50. Now say you instead sold a $50 strike price. Now the value might be $1.00. The theta value is now $1, which is much greater. However, in the last example, if the stock dropped from $50, to $40, you would still end up with a slight gain. In this example, if the stock fell to $40, you would incur a $9 a share loss.

Now lets say you buy a stock with $50 a share, and sell an option at $60 a share. Now this option might cost you $0.50. Again the time value is 0.50. The difference is, now you have room for your stock to go up and less of your upside is capped. However, Now if your stock goes to $40, that’s a $9.59 loss. These aren’t real numbers based on a real stock and real options, but they illustrate the point. The point is that whether you buy or sell a stock option depends on your outlook, and what strike price you are looking at.

Buying and selling options have advantages.

As the buyer of a call option, you are saying, I believe this stock will go up. You would buy an at the money option because you want the full leverage per 100 shares and you want to get as close to a gain as 100 shares as you can. You would buy a deep in the money option because you want to pay less for theta, allow you to lose a smaller amount percentage wise, keep actual money tied up so you aren’t tempted to put more leverage on or if you do you have better money management. You need less of a move to make money with a deep in the money option, and it’s practically buying the stock for a discount if you buy deep enough in the money.

As the buyer of an out of the money option, you first must have enough money on the side, but you believe that if you can get a stock to move big, that you should bet big, you allow yourself to buy more shares and diversify while still keeping a lot of capital on the side (which you will have to do). If you can manage your larger swings, these have limited time value, and very high upside. Now a covered call is when you own the actual stock so things will be different.

A covered call you would sell a deep in the money call if you want to collect the theta, but want to insure against greater losses and are willing to accept less for this protection. You would sell an at the money option because you want to collect the maximum theta, don’t believe the stock will decline much in value, but you don’t believe the upside will be that great. You would sell out of the money options if you bet on the stock being slightly bullish. This is just a start which tells you what to consider when determining what strike price to buy an option at, it does not tell you what to consider when determining whether you want a long term, or short term option, but thats another story.

Maclin Vestor teaches about variousstock trading systems and soon will teach you aboutforex trading systems in addition to stock trading.

Tags: forex, market, options, stock, Stock Options