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Started By
Message
By request: Buying and selling call and put options
Posted on 12/11/13 at 1:47 pm
Posted on 12/11/13 at 1:47 pm
In the SLV thread a poster started explaining how he uses options to make money. Several posts were made and then a poster requested a thread be started explaining how options work.
That is what this thread is for:
I'll start with a basic description of call and put options which I already posted in the SLV thread.
This is probably not the textbook way of explaining options but anyone else can certainly jump in to elaborate or improve my description of options below. I'm using the word "stock" generically as the underlying security/asset of the option contract. Options are also traded on other investments/assets including commodities and bonds. I am also assuming all of the options are marketable and traded via major brokers and have a mark-to-market price, which is not the case of some non-standard options.
A call option gives the buyer of the option the opportunity to buy a block of stocks (in lots of 100 shares) at a set (strike) price. The person who buys the call option pays a price to the seller (writer) of the call option and this price is called the "premium."
Obviously the buyer of the call option hopes and/or expects the price of the underlying stock to go up. If it does, and the stock's price exceeds the "strike" price, he can exercise his option and buy the stock at the lower strike price contained in the option and immediately sell the shares at a profit (minus what he paid for the option).
Or, he can simply sell the option itself which has also increased in price because the underlying security has increased in price.
A put option is the reverse; it gives the buyer of the option the opportunity to SELL the underlying security at a set price. The buyer of a put hopes and/or expects the stock's price to fall and he can make a profit if the price of the stock falls below the strike price of the option (minus what he paid for the option). Like a call option, a put option also has a market value and if the price of the underlying security falls, the market price of the put option goes up. So the buyer of the put can simply sell his option and make a profit, again minus what he paid for the option.
Put options are also used to protect the downside risk of a security owner just in case his stock declines in price. He can guarantee himself a price at which he can sell his stock.
That is what this thread is for:
I'll start with a basic description of call and put options which I already posted in the SLV thread.
This is probably not the textbook way of explaining options but anyone else can certainly jump in to elaborate or improve my description of options below. I'm using the word "stock" generically as the underlying security/asset of the option contract. Options are also traded on other investments/assets including commodities and bonds. I am also assuming all of the options are marketable and traded via major brokers and have a mark-to-market price, which is not the case of some non-standard options.
A call option gives the buyer of the option the opportunity to buy a block of stocks (in lots of 100 shares) at a set (strike) price. The person who buys the call option pays a price to the seller (writer) of the call option and this price is called the "premium."
Obviously the buyer of the call option hopes and/or expects the price of the underlying stock to go up. If it does, and the stock's price exceeds the "strike" price, he can exercise his option and buy the stock at the lower strike price contained in the option and immediately sell the shares at a profit (minus what he paid for the option).
Or, he can simply sell the option itself which has also increased in price because the underlying security has increased in price.
A put option is the reverse; it gives the buyer of the option the opportunity to SELL the underlying security at a set price. The buyer of a put hopes and/or expects the stock's price to fall and he can make a profit if the price of the stock falls below the strike price of the option (minus what he paid for the option). Like a call option, a put option also has a market value and if the price of the underlying security falls, the market price of the put option goes up. So the buyer of the put can simply sell his option and make a profit, again minus what he paid for the option.
Put options are also used to protect the downside risk of a security owner just in case his stock declines in price. He can guarantee himself a price at which he can sell his stock.
4
Posted on 12/11/13 at 1:51 pm to LSURussian
The poster rmc posted the following examples of buying options in the SLV thread:
quote:
I sell Lsut81 1 contract SLV for $20 per share by December, 21, 2013 for $.10/share.
You would give me $10 (.10 x 100) for the premium.
On or before December 21, 2013 you would have the option of buying 100 shares of SLV for $2000 ($20 x 100) from me.
So how does this benefit you? Well, if shares of SLV are trading for $25 on December 20, 2013, you'd make a profit of $490 ($2500 - $10 - $2000) if your turned around and sold the shares.
If the price stays below $20, it doesn't make much sense for you to buy at $20 and you'd just let the contract expire. In that scenario I just made $10 from the premium.
A covered call means you actual own the underlying asset.
Posted on 12/11/13 at 2:11 pm to LSURussian
I have been wanting to start a similar thread re: the tax treatment of option premiums - so I apologize if this is somewhat off-topic, but I will go ahead and ask here:
Can I include the premium in the cost basis of my shares for tax purposes, assuming I exercise the option and sell/buy-back the related shares?
My gut tells me yes, but I normally don't exercise options so I have no experience in this.
Can I include the premium in the cost basis of my shares for tax purposes, assuming I exercise the option and sell/buy-back the related shares?
My gut tells me yes, but I normally don't exercise options so I have no experience in this.
This post was edited on 12/11/13 at 2:12 pm
Posted on 12/11/13 at 2:29 pm to sneakytiger
I believe the premium collected is taxed as ordinary income in most cases. The cost basis for the stock if you exercise a call, or have a put exercised against you, is the strike price, commissions and fees. This should all be in your year end statement.
I like to write (sell) both calls and puts. Data suggests that 75% of options expire worthless. Data also suggests very few options are ever exercised.
A lot of exercises are done right before a stock goes ex-dividend.
There are types of options exercise rights. American style, and Eurpoean style. American style can be exercised at any time. European style can be exercised only at expiration.
VIX options settle on a different date. Weekly options settle weekly. Almost all others (monthly) settle the 3rd Friday of the month.
LEAPS are options you can buy out as far as 24 months. For example, in the SLV thread, I cited buying a Jan, 2016 option on the underlying security.
I like to write (sell) both calls and puts. Data suggests that 75% of options expire worthless. Data also suggests very few options are ever exercised.
A lot of exercises are done right before a stock goes ex-dividend.
There are types of options exercise rights. American style, and Eurpoean style. American style can be exercised at any time. European style can be exercised only at expiration.
VIX options settle on a different date. Weekly options settle weekly. Almost all others (monthly) settle the 3rd Friday of the month.
LEAPS are options you can buy out as far as 24 months. For example, in the SLV thread, I cited buying a Jan, 2016 option on the underlying security.
Posted on 12/11/13 at 2:31 pm to Iowa Golfer
I forgot. VIX options also settle in cash I believe. I've never settled one. I usually just sell it at a profit.
Posted on 12/11/13 at 2:36 pm to Iowa Golfer
Also, with respect to the tax treatment, you should not rely on me, but your tax advisor and year end brokerage statement(s). I'm unusual in that I don't care how things get taxed. Within reason. I really only care about making gains.
I care about making gains more than I care about any other thing in this world.
I care about making gains more than I care about any other thing in this world.
Posted on 12/11/13 at 2:44 pm to Iowa Golfer
I'm buying and exercising puts in this scenario - my broker statement correctly shows cost per share equal to the exercise price, less premium and commissions/fees. I'm just not certain if I get to deduct the premium in my capital gains/losses.
Posted on 12/11/13 at 2:47 pm to LSURussian
quote:
seller (writer)
This is horribly risky. You make steady returns and think everything is going great, so heck, you write more options. Then, a 2008 type correction, or even a May 2010 flash crash happens, and you could lose everything you've got in your account in one horrible day.
quote:
Put options are also used to protect the downside risk of a security owner just in case his stock declines in price. He can guarantee himself a price at which he can sell his stock.
This, to me, is where options can be very handy. Say a buyer bought a stock in January and something great happens and the stock jumps 100% or more and come November the owner would like to cash in. But wait, if he can hang on for another two months he'll pay long term capital gains instead of short term (20% difference on taxes). So he calculates his capital gains difference and hedges with some put options (or calls if he's short).
Posted on 12/11/13 at 2:55 pm to sneakytiger
It's past me. I'm not sure if your exercising of the put involves shares you already own, or not.
Below is what my broker indicates for stock sold through an exercised put option:
Realized Gain or Loss from Stock Sold through Exercised Put Options
When you sell stock through the exercise of a put option, your realized gain or loss is equal to the total amount received from selling the stock, minus the cost basis of the underlying security, minus the cost basis of the put option. The option position itself is closed without any gain or loss.
For example, if you buy 500 shares of a stock at $21.00 per share and pay $10.00 in commissions, the cost basis of your stock is:
(500 x $21.00) + $10.00 = $10,510.00
Share Quantity x Price Paid per Share + Commission = Cost Basis of Underlying Security
Then, you buy 5 put options at $0.30 per contract where each contract represents 100 shares and you pay $13.75 in commissions, your cost basis for the options is:
(5 x $0.30 x 100) + $13.75 = $163.75
Option Premium Paid + Commission = Cost Basis of Options
Then, you exercise your put options at a strike price of $25.00 and pay $20 in commissions. The amount received from selling is the stock is:
(5 x $25.00 x 100) - $20 = $12,480.00
Proceeds of Underlying Security - Commission = Amount Received from Underlying Security
Your total realized gain is:
$12,480.00 - $10,510.00 - $ 136.25 = $1,833.75
Amount Received from Underlying Security - Cost Basis of Underlying Security - Cost Basis of Option = Realized Gain
As
Below is what my broker indicates for stock sold through an exercised put option:
Realized Gain or Loss from Stock Sold through Exercised Put Options
When you sell stock through the exercise of a put option, your realized gain or loss is equal to the total amount received from selling the stock, minus the cost basis of the underlying security, minus the cost basis of the put option. The option position itself is closed without any gain or loss.
For example, if you buy 500 shares of a stock at $21.00 per share and pay $10.00 in commissions, the cost basis of your stock is:
(500 x $21.00) + $10.00 = $10,510.00
Share Quantity x Price Paid per Share + Commission = Cost Basis of Underlying Security
Then, you buy 5 put options at $0.30 per contract where each contract represents 100 shares and you pay $13.75 in commissions, your cost basis for the options is:
(5 x $0.30 x 100) + $13.75 = $163.75
Option Premium Paid + Commission = Cost Basis of Options
Then, you exercise your put options at a strike price of $25.00 and pay $20 in commissions. The amount received from selling is the stock is:
(5 x $25.00 x 100) - $20 = $12,480.00
Proceeds of Underlying Security - Commission = Amount Received from Underlying Security
Your total realized gain is:
$12,480.00 - $10,510.00 - $ 136.25 = $1,833.75
Amount Received from Underlying Security - Cost Basis of Underlying Security - Cost Basis of Option = Realized Gain
As
Posted on 12/11/13 at 3:02 pm to sneakytiger
Poodlebrain is the Money Board's resident tax expert. He's a CPA and knows his stuff. He'll probably post in this thread once he sees your tax question.
Posted on 12/11/13 at 3:05 pm to LSU0358
@LSU0358
quote:
seller (writer)
This is horribly risky. You make steady returns and think everything is going great, so heck, you write more options. Then, a 2008 type correction, or even a May 2010 flash crash happens, and you could lose everything you've got in your account in one horrible day.
(Not necessarily. Your risk on a put you write is that you have to buy the underlying asset at a strike price, so you do get something of some value in a very worst case scenario). Again, most options aren't exercised. Long before the exercise, if the trade was going bad, you could buy a put, to close the put you sold. Sold a put, later buy the same put at a limit, position closed, danger over.
Uncovered calls, if your broker even allows you to do this, can be risk managed as well. Using a variety of orders for the underlying security, or simply a limit buy order for the call you sold, consequently closing the position, long before things got out of hand. There is a reason why brokers require customers to apply for options, and also a reason that there are 4 levels of approval. It took my broker about a year to give me level IV. It is helpful if you have the ability, based on balances, to cover)
quote:
Put options are also used to protect the downside risk of a security owner just in case his stock declines in price. He can guarantee himself a price at which he can sell his stock.
This, to me, is where options can be very handy. Say a buyer bought a stock in January and something great happens and the stock jumps 100% or more and come November the owner would like to cash in. But wait, if he can hang on for another two months he'll pay long term capital gains instead of short term (20% difference on taxes). So he calculates his capital gains difference and hedges with some put options (or calls if he's short).
(Options have a large variety of risk management and leverage purposes. Even the most risky options strategies can be risk managed to provide a maximum loss.)
quote:
seller (writer)
This is horribly risky. You make steady returns and think everything is going great, so heck, you write more options. Then, a 2008 type correction, or even a May 2010 flash crash happens, and you could lose everything you've got in your account in one horrible day.
(Not necessarily. Your risk on a put you write is that you have to buy the underlying asset at a strike price, so you do get something of some value in a very worst case scenario). Again, most options aren't exercised. Long before the exercise, if the trade was going bad, you could buy a put, to close the put you sold. Sold a put, later buy the same put at a limit, position closed, danger over.
Uncovered calls, if your broker even allows you to do this, can be risk managed as well. Using a variety of orders for the underlying security, or simply a limit buy order for the call you sold, consequently closing the position, long before things got out of hand. There is a reason why brokers require customers to apply for options, and also a reason that there are 4 levels of approval. It took my broker about a year to give me level IV. It is helpful if you have the ability, based on balances, to cover)
quote:
Put options are also used to protect the downside risk of a security owner just in case his stock declines in price. He can guarantee himself a price at which he can sell his stock.
This, to me, is where options can be very handy. Say a buyer bought a stock in January and something great happens and the stock jumps 100% or more and come November the owner would like to cash in. But wait, if he can hang on for another two months he'll pay long term capital gains instead of short term (20% difference on taxes). So he calculates his capital gains difference and hedges with some put options (or calls if he's short).
(Options have a large variety of risk management and leverage purposes. Even the most risky options strategies can be risk managed to provide a maximum loss.)
Posted on 12/11/13 at 3:11 pm to Iowa Golfer
quote:
Options have a large variety of risk management and leverage purposes. Even the most risky options strategies can be risk managed to provide a maximum loss
I think that should be the lesson here. They are a great tool to hedge and replicate positions. But ultimately you are equivalently buying a stock on margin and they can be very dangerous if you don't know what you are doing. I don't recommend trying options unless you are a seasoned trader.
This post was edited on 12/11/13 at 3:12 pm
Posted on 12/11/13 at 3:23 pm to Iowa Golfer
quote:
(Options have a large variety of risk management and leverage purposes. Even the most risky options strategies can be risk managed to provide a maximum loss.)
I suspect you meant 'a minimum loss.'
Posted on 12/11/13 at 3:25 pm to barry
quote:This. It's the reason why brokers require additional paperwork to be completed before allowing the customer to trade options.
I don't recommend trying options unless you are a seasoned trader.
At least my broker, Schwab, does.
And Schwab does not allow me to trade options in my tax deferred (SEP, IRA) accounts.
Posted on 12/11/13 at 4:08 pm to LSURussian
quote:That's all I am to you?
Several posts were made and then a poster requested a thread be started explaining how options work.
Posted on 12/11/13 at 4:50 pm to ell_13
No, you are much more than that.
I was afraid everyone else would detect my man crush on you if I spelled out your screen name.....
I was afraid everyone else would detect my man crush on you if I spelled out your screen name.....
Posted on 12/11/13 at 5:59 pm to LSURussian
Well, now you gawn an' dun it.
Posted on 12/11/13 at 6:50 pm to ell_13
I buy and sell options on occasion and have on both equities and commodities. A few points to consider:
1) When you "sell" a naked call you have unlimited liability. Say you you sold a call on XYZ at $100 and the stock went to $10,000. You have the liability to deliver XYZ at $100 even though you would have to pay $10000 for the stock. I do in my IRA sell covered calls from time to time if I think price up side is not that good and down side risk is that that much. I might own 100 shares of XYZ at $100 and sell a $105 (out of the money) Jan call for $3 and pocket a nice return should the shares be called and pocket $3 either way. So long as XYZ does not go down more than $3 I am ahead. So I like covered calls.
2) Selling naked puts on a stock you are willing to own at current prices is a way to lower your net cost of the investment. If for example I willing to buy XYZ at $100 but I can sell a Jan $100 put for $2 if the option is exercised I have purchased the stock at a net of $98. Obviously it's price would have fallen to at least $98 or the option would not have been called BUT I was willing to buy at $100 anyway.
3) Owning options limit your losses. What you pay for a call or put if you buy them is all you can lose.
Straddles are good strategy for options traders.
Very good book on the subject:
LINK
I will warn you--sometimes options are thinly traded--particularly in agricultural commodities. If you want to trade be sure to look at the volume in options you are interested in.
ALSO premiums naturally shrink the closer you get to the settlement date.
1) When you "sell" a naked call you have unlimited liability. Say you you sold a call on XYZ at $100 and the stock went to $10,000. You have the liability to deliver XYZ at $100 even though you would have to pay $10000 for the stock. I do in my IRA sell covered calls from time to time if I think price up side is not that good and down side risk is that that much. I might own 100 shares of XYZ at $100 and sell a $105 (out of the money) Jan call for $3 and pocket a nice return should the shares be called and pocket $3 either way. So long as XYZ does not go down more than $3 I am ahead. So I like covered calls.
2) Selling naked puts on a stock you are willing to own at current prices is a way to lower your net cost of the investment. If for example I willing to buy XYZ at $100 but I can sell a Jan $100 put for $2 if the option is exercised I have purchased the stock at a net of $98. Obviously it's price would have fallen to at least $98 or the option would not have been called BUT I was willing to buy at $100 anyway.
3) Owning options limit your losses. What you pay for a call or put if you buy them is all you can lose.
Straddles are good strategy for options traders.
Very good book on the subject:
LINK
I will warn you--sometimes options are thinly traded--particularly in agricultural commodities. If you want to trade be sure to look at the volume in options you are interested in.
ALSO premiums naturally shrink the closer you get to the settlement date.
This post was edited on 12/11/13 at 6:54 pm
Posted on 12/11/13 at 7:28 pm to I B Freeman
I don't believe you always have unlimited liability with naked calls. You can place a conditional order to either purchase the underlying security at a set price, or buy the call back at some level of loss based on how far up the underlying security goes up.
Theory -v practice.
I sell naked calls, and place conditional orders to buy the call back at a loss all the time. The condition that my buy to close is predicated on is the price of the security. If your brokerage account guarantees execution of conditional orders, then you have no worries. except a set loss on the call. The set loss being you sold it for $3, and you have to buy back the call for $5 as an example.
Theory -v practice.
I sell naked calls, and place conditional orders to buy the call back at a loss all the time. The condition that my buy to close is predicated on is the price of the security. If your brokerage account guarantees execution of conditional orders, then you have no worries. except a set loss on the call. The set loss being you sold it for $3, and you have to buy back the call for $5 as an example.
Posted on 12/11/13 at 7:32 pm to Iowa Golfer
quote:
I don't believe you always have unlimited liability with naked calls
Yes it is theory v. practice.
Would not have wanted to written a bunch of naked calls on Oct. 18, 1987.
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