Stock Option Trading

The term stock options takes on several meanings as it's bandied about the investing community. For the general public, stock options refers to a perk afforded to corporate executives, and lately not in a particularly positive light.

For the investor, however, stock options are investment tools that allow you to leverage the price swings of stocks without investing in the stocks themselves. It's a high risk/reward game. You can, for a few pennies on the dollar, participate in the upswing of a stock on a dollar for dollar basis, with returns measured in the hundreds of percentage points.

Or, if you guess wrong, you can lose significant portions of your investment, even all of it if you don't move quickly enough, by sitting on your hands.

The Four Corners of Options Trading

What’s less obvious, though, at least at a glance, is that you have four primary avenues of investing in options, both on the buy and sell side, and both from a bullish and bearish perspective.

For every trade there is a winner and a loser. And because stocks go in both directions, that means they come from both sides of the transaction.

There are two types of stock option contracts, puts and calls.

Puts allow you to sell stock to someone else at a given price, within a given time.

Calls allow you to buy stock from someone else at a given price, within a given time.

Most often we focus on the buy side of these transactions, we buy calls, we buy puts, and we hope to sell them back into the market for a gain. With calls the gain comes when the stock goes up, with puts the gain comes when the stock goes down.

But the other side of these transactions is a viable strategy, as well. Because for every buyer of a put or a call option contract, someone out there is selling it to them. And they're pocketing money in the process.

Writing Options Contracts

Fewer investors, however, take a close look at the selling side. Selling a call option contract can be a conservative hedge, resulting in immediate cash flow as well as locking in profits while protecting against a downward spiral.

And selling a put contract can net you positive cash flow when the stock tanks.

Let's say you own 100 shares of XYZ company, for which you paid $19 per share. If call options at a $20 strike price are selling for $3 (or $300 for the contract), you could sell, called writing, a call option for someone to buy your 100 shares at that $20 price, and you'd pocket the $3 premium immediately.

Then, if the stock goes above $20, you'll be stuck with the obligation to sell at $20. But that's still a $1 per share profit from your $19 acquisition cost, and you get to keep the $3 premium, for a total return of $4 on your $19 investment, or over 21 percent.

The Writing Risk

The risk here is your forfeiture of the profit above $20, but you knew this when you accepted the $3 premium for the option, which at the time was all just guesswork and not remotely guaranteed. In effect, you aren't behind until the stock goes above $23. And, 21% isn't bad, and if it happens over a few months, that could equate to well over a 50% annualized return.

On the other hand, that same trade hedges you against the downside, as well. If your stock sinks to, say, $16, nobody will exercise the option, which means you will keep the stock, perhaps to sell another option on it another day. You also keep the $3 option that you sold, which means your cost basis at a $19 purchase is $16, you've broken even while everyone else who got in at $19 has a three dollar lose.

Writing put contracts works just the same way, you receive money by giving someone the right to sell you 100 shares of stock at a given price. If the price of the stock goes up, that won't happen and you'll get to keep the premium. If it goes down, you are protected to the extent of the proceeds of the option sale.

Which makes writing puts as speculative as writing calls is conservative. Because your upside is limited to the proceeds of the sale, and downside extends to the full value of the stock itself, which could theoretically go to zero.

They don't call them options for nothing. Because you have four of them, four ways to invest on both sides of the price swing, and on both sides of the transaction and price swing pivot points.