The Stock Option
MDC just spent the weekend with Ojore and Kamau and they are sharing some knowledge.
While nothing is for sure with investing, there are ways to use financial instruments called options to attempt to milk more profit out of stocks that are already owned or to lock in gains on winning stocks.
Before explaining how options can help investors lock in gains, first a word on what options are. Options are financial instruments that give buyers the right, but not the obligation, to buy assets at a preset time in the future at a preset price.
Options can be used by speculators to place wild bets on stocks, and that’s why they often get a reputation for being for advanced traders. But used properly, usually in connection with a stock that an investor already owns, options can actually be very conservative and prudent.
There are two main types of options, puts and calls. Puts give their owners the right to sell a stock to someone else at preset price at a certain date in the future. Calls give their owners the right to buy a stock at a preset time and price in the future.
We are going to speak on two options strategies considered to be pretty conservative. Both have interesting outcomes for investors, who are playing it safe. They are:
1) Locking in gains with a “protective put.” If you own a stock that’s been a big winner, and you don’t want all your gains to slip away, then a protective put might be for you. Let’s say you bought a stock for $100, and the stock is now $200. You have a big gain you don’t want to lose, but you don’t want to sell either and risk missing any future upside. You might consider buying a put that gives you the right to sell your stock for $180, or instance. For a price, which is determined by the options market, even if the stock falls to $50 a share, you can sell for $180.
The protective put essentially guarantees you’ll keep a profit on a winning stock. Keep in mind, though, that protective puts won’t turn a losing stock into a winner. You can use protective puts, though, to make sure a losing stock doesn’t get worse, for a fee.
2) Hauling in income with a covered call. Most investors realize dividends can be a valuable source of income generated by a stock. But some might not know that options, too, can be used to bring in an income stream on a stock that’s already owned.
Here’s how it works. Typically, investors will sell calls to investors for a stock they own at a price that’s higher than the current stock price. The buyer of the option will pay the owner of the stock a fee, or premium. If the stock stays where it is, or even falls, investors can keep selling the calls over and over again and collect the premium. The premiums are like an income stream.
Keep in mind, though, that this trade is not guaranteed to stem losses or last forever. If the stock falls, the value of the stock falls, too. Covered calls don’t provide protection from stock price declines, either, while the income from the calls can help ease the pain. Also, if the stock takes off and soars, the owner of the call will buy the stock from you at the lower price.
Options can be useful tools for even beginning investors.
The key is to understand how they work and what they will cost you.