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November 14, 2007

More Option Basics and the Covered Call

Posted in: Retirement Investing, Options

Okay, so yesterday may have been a little much for some readers that are new to the option world. So I will back track just a little. Options are traded in increments of $5 strike prices for stocks over $25. For stocks under $25, they are traded in $2.50 increments. That means that you can usually buy the $20 strike price, the $22.50 strike price, the $25, $30, $35, etc for any given month. The market value of each option is based on 2 things. The first is intrinsic value, or what the difference is between the strike price and the market price. So what is a $30 call worth if the market value is $33. Intrinsically, it is worth $3 because I can call it from someone at $30 and sell it for $33. The second value is time value. So the further away the expiration date, the higher the time value is.
One thing to remember, options for a given month expire on the 3rd Friday of the month.

The Covered Call
This is probably the most basic form of trading options. This type is often times what brokerage firms will allow you to trade with out any options experience. Selling a covered call is generally seen as having very little risk, and it is even allowed in your Roth IRA or Traditional IRA.
The fundamental of this trade is that you own the underlying stock. You are then selling someone else the right to buy that stock from you at a certain price (strike price) on or before a certain date (expiration date). Of course for this privilege, you will charge a premium. The premium can fluctuate as often as the stock price. If the stock price goes above the strike price before the expiration, someone will call the the stock away from you. You get to keep the premium, and you sell the shares of stock at the agreed upon price (strike price). If the stock stays below or at the strike price, the call expires worthless, and you keep the premium and the stock.
Example Time:
Say I own 1,000 shares of ZYX stock, which is currently valued at $27.50. The $30 Dec call option is currently valued at $.55. So to execute the covered call trade, I would sell 10 contracts (each contract equals 100 shares) at $.55 a share. This would equal the premium that someone would give me in exchange for the right to call those 1,000 shares away from me at any point until 21 December (the expiration date). So my total premium would be $.55 x 1000 = $550.
Question: What happens if the stock goes to $31 before December 21st?
Answer: The purchaser of my call option would call the shares from me for $30 a share. So I would get the $30,000 for the sale of the stock plus keep the $550 for a total of $30,550.
Question: What happens if the stock stays below $30 a share until December 21st?
Answer: I would keep the 1,000 shares and the $550. I could then sale the January or February options to continue making a profit.
This option is usually used when you believe that a stock that you currently own is not going to increase in value beyond the strike price before the expiration date.

In my next post, I will continue deeper into our endeavor of potential ways to make money through options in this volatile market. Feel free to continue asking questions and posting comments.

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