Options Selling
Options Selling Strategy – Wk 4 June 2017 [Keryx Pharmaceuticals (NASDAQ: KERX)]
Chris Lee Susanto, Founder and CEO, Re-ThinkWealth
24 June 2017
Many of you might have heard of selling options as an income generating strategy. Maybe you have attended an investment course on it or you have read about it somewhere online.
Options are a form of derivatives — financial instruments whose price is derived from other underlying financial instruments — In the case of options, their prices are derived from stocks.
Before we delve further, you should know that not all stock market allows options trading. For example, we cannot sell options in Singapore stock market but we can sell options in the United States stock market.
When my friends asked me to explain to them what is options selling, I give them this explanation.
Options selling is like providing insurance contract to people and in return, we receive a premium from them. That premium we received from selling options is the cash flows that we generate.
Why do we receive premium you may ask? The answer to that is because we are taking on risks as an option seller when we do options selling.
In return for the risks we are taking, we receive a premium. More on the risks will be explained in the examples further below.
As with any contract, there is a time factor involved. We can either sell a weekly, monthly or yearly options contract.
Do note that there are a variety of options characteristics out there but they can be zoomed into put and call options. From there, we can either buy or sell those put and call options.
There are mainly two strategies to options – we can either do covered or naked options.
For my investing blog, we will be focusing on selling covered put and call options because that is what I practised myself.
Always remember that each options contract is worth 100 stocks.
That means that when you are selling covered call or covered put, you need to have 100 of those stocks you are ready to sell or enough cash to buy 100 of those stocks by the contract expiry date.
When you sell covered put options, you have the obligation to buy the stocks by the contract expiry date — if the price of the stocks is below the price you sold the put options at. You need to make sure you have sufficient cash to buy the stocks.
I see that Apple Inc (NASDAQ: APPL) is currently selling at 143 USD. I want to buy 100 of the stocks — only if it is below 135 USD.
So, what I do is that I sell 1 contract of the put option for the expiry date one month from today at the price of 135 USD.
In return, I get 200 USD for doing that.
The risk is that if Apple Inc stocks fall to 100 USD one month from now, I still need to purchase it at 135 USD (that is a 35% immediate unrealized capital loss).
However, since I view anything below 135 USD as undervalued, it is alright for me.
When you sell covered call options, you have the obligation to sell the stocks by the contract expiry date – if the price of the stocks is above the price you sold the call options at. You need to make sure you have the stocks to sell it.
I see that Apple Inc (NASDAQ: APPL) is currently trading at 143 USD. I had already bought 100 the stocks at 135 USD.
So, what I do is that I sell 1 call option for the expiry date one month from today at the price of 143 USD.
In return, I get 234 USD for doing that.
The risk is that if Apple Inc stocks rise to 171.60 USD one month from now, I still need to sell it at 143 USD (that is a further 20% potential capital gain that I missed out).
However, since I view anything above 143 USD as overvalued, it is alright for me.
While there are many options strategies in the financial world, what has served me well for the last couple of years is the combination of selling put and call options.
This strategy works especially for a value investor.
Because I have never borrowed money to invest (using margin), I have the holding power to take advantage of market opportunities during unexpected times.
In such opportunities, I receive a high amount of income via selling options and at the same time, leveraging on only buying stocks when my valuation says it is undervalued and only selling when it is overvalued.
After doing my FA, I concluded that GME should be worth at least 25 USD and I am only willing to own it if it is 21.5 USD and below.
So, what I did was that I sold covered put on GME at 21.5 USD for the contract expiry date of 24 March 2017 receiving 0.55% in premium.
On the contract expiry date, GME was at 20.7 USD and because of me selling covered put, I must purchase GME at 21.5 USD.
It rallied up to about 25 USD but I have not sold it yet. Shortly after, it fell back down to about 21.5 USD as of 15 June 2017.
In between, I also received dividends payment of about 1.7% which will be paid 20 June 2017.
After I bought GME at 21.5 USD, I sold a 30-day covered call option for the strike price of 26 USD (which is the price I am willing to sell my stocks at) — which expired in May 2017 for a profit of 0.14%.
On another 4 occasions, I sold puts for GME which ranged from 17 days, 2 days, 1 day and 15 days — receiving 2.25%, 0.44%, 0.29% and 1.21% in profit.
The most recent put that I sold for GME has exercised as well as the price for GME that day was 20.59 USD. I had to buy GME at 21.5 USD.
I am perfectly fine with buying more of GME because my FA concluded that it is still undervalued.
On 19 June 2017, I sold call options for all my holdings in KERX at the strike price of 7 USD expiring on 21 July 2017. The premium that I received was rather high– 3.32% based on my initial cost.
It was a good return for one month, especially because it is a realised profit.
More importantly, I have some thoughts about the drawback of selling call options and with it the good thing about selling call options.
The reason for my thoughts was triggered by the rallying of KERX in one day:
Image Source: Chris’s iPhone Stock App
As you can see from the above image, KERX rallied 5.63% in one day and closed the day at 6.75 USD. 0.25 USD away from 7 USD– my call options strike price– the price that I have to sell KERX at upon the expiry of the options if the market price is above 7 USD then.
Because I have sold calls for all of my holdings, that means that if the price went up to 7 USD and above before my options expired, I cannot sell any of its stocks. That is because I am selling covered call.
That means that in return for the 3 plus % realised profit I received, I am giving away my opportunity to sell off the stock earlier than the expiry date.
That can be an opportunity cost if you are looking to sell your stocks fast or you are looking to take advantage of the irrational rallying of the stock price.
Throughout my life, I realised and concluded one thing– the stock market is irrational and quite impossible to predict.
That is why I have also accepted that even if KERX rose to 10 USD by my expiry date and I still have to sell it at 7 USD, I will be contented because I have come to a decision that I want to sell it at 7 USD.
Disclaimer: The information provided is for general information purposes only and is not intended to be a personalized investment or financial advice.
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