Monday, 17 July 2017

Options Trading

Stock Options in the forms of call and puts can be a great tool for risk mitigation. Call it a form of insurance. The auto or house premiums that you keep paying ensure that you are compensated in the event your car is involved in an accident or that your house catches fire.

Definition of option as follow from Investopedia

An option is a financial derivative that represents a contract sold by one party (the option writer) to another party (the option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date).

Applying it to practice takes effort, patience and paying tuition fees upfront (i.e. pay the price initially and learn from mistake).  I find that my most successful options trades are not the one that are speculative in nature (i.e. banking that a stock is going to increase significantly by buying calls or thinking that a stock is going to tank by buying puts), but the option strategy that works best is writing covered calls.

Writing covered calls basically means that I own a stock, say 1,000 shares of TD Bank.  To further generate additional returns, I write a call for 10 contracts of TD Bank (1 contract = 100 shares) to sell at a strike price of $70 in 3 months (current price = $65 per share).  In return, I received a premium of $1,000 (or $1 X 10 contracts X 100 shares). 

My assumption is that since the stock has already appreciated 30%,   the stock has already reached its upside, and in the short term I assume that the stock will either decline or remain unchanged. If the share price stay below $70 for the next 3 months, the option will expire worthless. If the share price is above $70 prior to expiration, the buyer of the call will receive the shares at $70.  Regardless of the outcome, I still keep the premium, and therefore I am able to increase my return by another $1,000. There is obviously commissions involved.

In summary, there are various options that can be employed such as the basic buy or sell puts, writing calls and puts, to more exotic strategies such as straddles, collars, and etc. However, they can be quite costly for the inexperienced investor to participate in. 

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