A simple strategy to generate income or build positions can be accomplished using options. For those not familiar, an option represents the right to buy or sell shares of stock at a specified price during a set time period. The specified price is known as the strike price, and the time period is set by an expiration date. Options are bought and sold in units called contracts. One contract equals 100 shares of stock. The seller of the option is called the writer.
Two types of options are:
- Call options – Each contract gives the buyer the right to buy 100 shares of the underlying stock at the strike price up until the expiration date.
- Put options – Each contract gives the buyer the right to sell 100 shares of the underlying stock at the strike price up until the expiration date.
If the buyer exercises the option by the expiration date, then the writer must either sell to the buyer (call option) or buy from the buyer (put option) at the contract price, better known as the strike price.
Let’s look at Apple (GM:APPL) to see how we can use put options to generate income or build a position. Suppose you want to own 100 shares of Apple stock, but based on your in-depth research and analysis do not want to pay more than $380 a share. You could wait and hope that Apple drops to your target or you could write some puts at a strike price of $380. I use a short time horizon with this strategy, usually no more than two months out.
Below is a list of expiration dates based on Apple's closing price on Sept. 26, 2011 of $403.17.
The longer your time horizon, the higher the premiums, since longer durations equal greater risk. We’ll look at the Nov. 19 puts as listed below. The first column is the strike price, the second the bid and lastly the ask price.
The last two strike prices ($405 and $410) are highlighted because they are referred to as “in the money,” which is when the strike price is above the market price of the underlying stock price, i.e. the put option is worth exercising for the buyer, since the buyer can sell the stock above market price.
The premium is the sum of the options time value and intrinsic value. The intrinsic value is the “in the money” portion of the options premium. An example would be a put option with a strike price or $405 minus the market price of $403.17 equaling an intrinsic value of $1.83. If the market price exceeds the strike price, the intrinsic value is zero. The remaining amount would be the time value. Note that the higher the volatility of the underlying asset and/or the longer duration to expiration, the higher the time value premium, since higher volatility and/or increased duration equates to greater risk.
Now back to the put option strategy: You can write a put with a strike price of $380 for $15.75/share. So you write a put for 1 contract (100 shares) at $15.75 per share. The buyer pays you $1,575.00 for the right to sell you 100 shares at $380.00/share.
Let’s say you were successful as the writer of the puts described above. $1575.00 will be added to your account (before commissions and fees, which would be about $17.75 with Ameritrade). You could buy the put back, depending on how the underlying asset performs, but this is a wait-and-monitor strategy as long as the fundamentals do not change.
Now let’s fast-forward to the expiration date.
Case l: Apple is above the strike price. The option expires worthless to the buyer and the writer pockets the premium. Why? The buyer can sell his stock for a higher price on the market than selling to the writer at the strike price. The option writer can start the process again and write a new option contract if so desired.
Case ll: Apple is below the strike price. The writer is put the stock, buying 100 shares at $380.00 for a total of $38,000.00. The basis cost is lower since the premium collected was $1575.00. The final basis cost (before commissions and fees) is $380-$15.75 or $364.25 per share.
Risk: Regardless of how far Apple drops, the writer is obligated to buy at $380 per share. This is why it’s important to monitor any changes in the fundamentals of the underlying asset.
A few stocks we’ve used this strategy with are Microsoft (MSFT), Intel (INTC), Corning (GLW), Harris (HRS) and Hewlett-Packard (HPQ). We’ll use HPQ as an example to highlight the risk. Things changed extremely fast in August when then HP CEO Leo Apotheker announced strategic alternatives for the company's Personal Systems Group, causing some customers to rethink their relationships with HP. He also revised guidance, and announced the acquisition of Autonomy at a price viewed as excessive by the market. The stock tanked, creating paper losses for put option writers at the higher strike prices.
This strategy carries the same risk as a stock buy on the open market, although the basis cost may be slightly less, as the above example illustrates.
In summary, the option writer will either purchase the stock (if the underlying stock price is below the strike price) or walk away with the income generated from the put option (if the underlying stock price is above the strike price at expiration). The strategy should only be used for stocks you want to own at a price, based on your due diligence/research.
Fair value calculations and targets for stocks mentioned in this article can be viewed here.