Right or Obligation? How Well Do You Know Your Options?

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Trading options is becoming less intimidating for a lot of people.

Recently, at The Oxford Club’s sold-out 21st Annual Investment U Conference in St. Petersburg, Florida, I asked our Members to share whether they trade options. A clear majority of the Members raised their hands.

Twenty years ago, at the same conference, maybe four or five people out of a crowd of hundreds would have raised their hands. Even five years ago, I could have expected only 10% of the group to have traded options before.

Along with the increasing public interest in options, there is also an increasing need for education so that investors can understand the administrative aspects of certain trades.

First, let’s tackle covered calls. When you own stock in a company and want to generate extra income, you can sell options against the shares that you own. This is called covered call investing.

Let’s say that you own shares of AT&T (NYSE: T), which is trading at $32. You can sell an option with a $35 strike price against your shares. After selling the option, you will receive cash immediately that is yours to keep no matter what.

However, by selling the $35 option, you also sell your buyer the right to take your stock from you at $35 at any time before the option’s expiration. If the shares begin trading for $38 a month before expiration, the buyer can take possession of them by paying you $35 per share.

If the shares begin trading at $33, the call buyer can take your shares only if they are willing to pay $35. This almost never happens because they can buy the shares at market for $33; but if the stock pays a dividend, the buyer may often take possession, even if at a small loss, to capture that dividend.

If the stock pays a dividend of $0.51, for example, and the call buyer takes possession of the shares, they can do so knowing that the difference between what they are paying you and what they are receiving from the dividend is in their favor. Therefore, you often see shares called away before expiration when a dividend is involved.

Of course, by taking the shares away early, the buyer must pay you the full $35 strike price and relieve you of any further risk or obligation. Because this transaction is often carried out outside of market hours, if the market crashes the following day… it’s their problem!

When selling puts, you have a similar setup. When you sell a put, you receive income immediately. In exchange for that income, you are obligated to buy the stock you sold the puts on at the strike price if the shares close at or below that value at expiration.

However, you can be forced to buy the shares at any time prior to expiration if you pay no more than the current price.

For example, if you sell a put on AT&T at $32 and the shares begin trading at $28, your put buyer can force you to take possession of the shares at $32 regardless of how much time is left until expiration. You can then sell the shares at market and realize a loss, or you can hold on to the shares and wait for them to recover.

Knowing your rights and obligations in options trading will allow you to make better, more informed decisions that could be critical to your portfolio and risk management.

Good investing,

Karim