[Newsphopick=Kingsley Lim] When people talk about derivatives and options, immediately these terms are associated with “financial weapons of mass destruction” as they are often called by the media. But the truth is a lot more expansive than the narrow definition given by the media. Yes, options can be dangerous instruments if used in the wrong way, but it could also help one to earn a passive income.
What are options? There are two types of options. There are call options and put options. With regard to call options, a buyer is typically bullish of market conditions. In general, if the price of the underlying security rises, the price of the call option rises as well. When that happens, the buyer can sell his call option for a profit. This is typically called “closing a position” by traders. The phrased “buy to open” accompanies the phrase “sell to close”. Similarly, the phrase “sell to open” accompanies the phrase “buy to close”. These are terminologies that one has to get used to understand the game of options trading.
With put options though, a buyer of put options is bearish and wants to take advantage of the fall in prices. Hence, if the price of the underlying security falls, the price of the put option increases. That is the reason why put options are an excellent tool for hedging.
Can’t one just buy and sell stock instead and get the same profit. Yes you most certainly can but options come at a fraction of the cost of buying shares, and could give you the same exposure that stocks give you. That is the reason why options are considered derivatives. While the label “financial weapons of mass destruction” refer to the harm if one uses these instruments improperly, it is quite likely that they have not considered the advantages of options.
I have spoken about buying and selling call options but do you know that you can sell both put and call options in the US stock market. Yes you can. But do remember that it works slightly differently. When you buy a call and a put option respectively, you have the right to buy and sell the underlying at a specific strike price on or before the expiration date.
So when one sells call options, one is obligated to sell the underlying securities to the buyer of the call options. When one sell put options, one is obligated to buy the underlying securities from the buyer of the put options.
Without trying to confuse matters, the objective of this is to share that one can earn passive income by selling put options. A seller of put options is also known as a writer of put options and hence the title of this article above. When one sells put options, he gets an option premium – the value of the option premium can depend on many factors. Sometimes, the option premium can amount to a few hundred dollars.
Now options are not instruments with an infinite lifespan. Eventually, they expire. The time to expiry is dependent on the contract that was written – and its specifications. So options have “time value” and this erodes away as the option contract approaches expiry. So the longer the “time value”, the larger the option premium.
A weird phenomenon occurs when options have only 30 days of time value left. The time value erodes at a rapid rate, if the option is not already in the money. So the idea is to sell high and buy low. When one sells a put option, he receives some premium of say $200 but as the option approaches expiry, the value of the option decreases dramatically and sometimes, expires worthless. That means that the value of the option goes to zero as it no longer has any time value.
When that happens, the option seller pockets $200 in premium. It is his to keep and this can serve as passive income for people who understand the game of options trading. But what if the buyer of the option exercises the put option and you are forced to buy shares from the buyer of the put option.
This is where it may get interesting and exciting for some. From my perspective of a value investor, the stocks that I intend to purchase must be at a low enough price to its estimated intrinsic value. For example, I intend to buy shares at $50 which are worth $100 in the long run. To do that I can buy shares directly in the open market or I can write a put option with a strike price of $50 for a premium of $2 per share of $200 per contract.
When that happens, if I do get an assignment notice of the shares, I have essentially bought the shares at a cost of $48 per share, as I have collected $2 in premium per share. Isn’t that a wonderful way to invest in the stock market?