The investor’s guide to safer options
Options aren’t just a wild gamble on the future of stocks, says this Canadian advisory. They can be a pretty safe way to get extra income.
You’re an income investor who could use more income — or any investor, for that matter.
Who wouldn’t like more cash these days?
So is there any way of doing it you might not have considered?
Options.
No, we’re not kidding you. There are options strategies that will make you money at much less risk than you might think.
There are also a lot of high-wire never-mind-the-safety-net options that insiders and pros use. That’s not what we’re talking about today.
One of Canada’s leading advisories for income investors, the Money Reporter, has been running a series of articles on the less dramatic approach to options.
We can’t cover them all (that’s a pun in the world of options) in one article. But we will see how an option can be both successful and safe, and draw on an example that explains the basic premise clearly.
We’ll start with one simple but vital piece of advice. Don’t try this with stocks you don’t know.
A fundamental rule
“When you trade options, there is a fundamental rule that should never be forgotten,” says this advisory. “You cannot have an opinion on an option unless you first have an opinion on the underlying stock.”
Only then can you decide what the appropriate options strategy will be and when you should exercise it.
You are either going to sell “calls” — the right to buy shares — or “puts” — the right to sell them. If you are bullish on a stock in the short term, there is certainly no point in selling puts. But neither is there any point in doing what is known as a “covered call.”
Writing a “covered call” means that you own shares in the company already. You’re executing what the pros call a “naked” option — i.e., one in which you don’t really own the shares. You’re not playing with borrowed money or plunging into uncharted territory. You know the stock.
There are various reasons you might have bought the shares, but essentially, says the Money Reporter, the fact you own the shares suggests “you are bullish on the share price over the long term.” But you may not be quite as bullish in the short term. That’s how you can pick up some extra income.
The side of caution
Before we actually write a covered call, here are two more pieces of advice from the advisory. When it comes to the time allotted for the option, err on the side of caution. “It’s often better to sell an option whose term is too short rather than one that is too long.”
If you are unsure whether to take out a one-month call or a two-month call, opt for one month. If it works out, you can always do a second one-month call when the first expires.
Second, be careful when you choose the price at which the option will be exercised, or the “strike” price. The higher the strike price, the less chance there is of your shares actually being called away. But the higher the price, the less you get for selling the option as the buyer’s risk rises.
OK, enough pre-game chatter. Let’s write a covered call option.
$1,000 free and clear
The advisory uses the example of BCE Inc. (TSX-BCE). Let’s say you have a thousand shares you’re willing to put on the options market.
Those shares are trading at $26. So you sell call options on that existing stock position of 1,000 shares. You can sell up to 10 BCE call options (call options are always for 100 shares each) giving another investor the right to buy the shares at $28 in three months.
If the premium set for the option is $1.00, you collect $1,000 for selling the options. That’s your money, no matter what.
Both you and the buyer have confidence that the stock will go up (it’s not likely you would own the stock otherwise).
But you’re convinced the stock will not go up $2 or more in the next three months. The buyer obviously thinks it will go above $28, so that he or she will get the shares at a discount.
If the buyer is right, you lose the future dividend income and capital gains on the shares, but keep the $1,000. If you’re right, you’ve got $1,000 free and clear and you still own the shares.
It’s not as safe as a GIC, admittedly. There’s still an element of chance in the process (and there are many permutations in the world of options that dictate the value of premiums and options, though they needn’t concern us here).
But the simple case stated above underlines the original rule put forth by the advisory. Know your stock. If you don’t have a sound idea of the stock’s prospects, you might as well just head for the roulette wheel.
Here is how the Money Reporter sums it up. “Selling covered calls represents an additional way to reap some income from stocks you already own and are receiving dividends on. It can be quite lucrative over time, so try to keep an open mind about it.”
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