Did you read those advertisements in the newspaper about how the specialists claim himself/herself to be able to help you make money for the rest of your life with his/her method or secret? The advertisements will further urge you to book a seat for a free preview in order to sell you the dream on how to write your own check every month without fail. During the free preview, chances are the specialists will show you how his/her students made X or Y amount of dollars by following his/her methodology. And if you want to do the same, you have to sign-up for the course (two or more days) which costs you a couple of thousand dollars.
Basically the method is pretty no-brainer, at least for those who’ve experience trading or investing in stocks option before. In a nutshell the juice of the method is quite simple and I’m going to tell you how it can be done within this article, free of charge. I’ll try to put it in laymen term as far as I can in order not to confuse the newbies. It’s all boils down to one of the many strategies in option trading. Do not fret out when the word option-trading is being mentioned as it’s just a name for another type of financial instrument, just like stock-warrants.
Mention stocks and chances are any Tom, Dick and dog will knows what it is. Option tied to stocks and without stocks, option can’t exist by itself. Option is just a contract that grants the owner (you) the right, without the actual obligation, to buy or sell 100 shares of stock at the strike price within certain expiration date. Why 100 shares? In U.S. one contract of option equals to 100 shares, as simple as that. Just like in Malaysia 1 lot of stock equals to 100 shares (previously were 1,000 shares though). Just remember that options can be “Call” or “Put”. You buy Call when you’re bullish about the stock and you buy Put when you’re bearish on a particular stock.
What I’m going to tell you here is the technique on how to write your own check every month the safe way (yes, there’s a risky way to it). It’s known as “Writing Covered Call” or “Writing Covered Put”. This is how it works:
- First, you need to own/buy the stock, 100 shares minimum because one contract of option equals to 100 shares. Example, you buy 100 shares of Guess at US$47.34 per share (that’s yesterday’s closing price) – your capital is US$4,734.00
- Now, you figured that Guess?, Inc. (NYSE: GES, stock) has been on the uptrend based on its 1-year chart. You also figured that $50 per share would be the strong resistance level for this stock and from you analysis, you might think the stock will not breach the $50 level, at least not for the next 29-days.
- If you already have a trading account, chances are you would have the option-chain data for the stock (diagram above). So based on the option-chain for Guess, you can actually write a Call option by selling 1 contract of Guess at Strike price of $50. Supposingly you sell at $0.70 per contract to the bidder, so you have just sold 1 contract of GES Jul 2007 50.0 Call. The very next day you would have US$70 less commission ($0.70 x 100) credited into your account.
- Congratulation, you’ve perform the role of a “Writer” by selling / writing Covered Call. If your prediction is right and by third week of Friday on July 2007 the Call option expires out-of-money (meaning the stock price closes lower than $50), you get to keep the US$70 less commission.
- But what will happen if the stock price closes above $50 (your prediction was wrong)? Now the concept is pretty simple, when you write/sell a Call, somebody on the other side is buying it (contrary to you, this fella is betting the stock will rise above $50). Holding this contract (or ticket), this fella will exercise his right to purchase the shares because it’s worth more than $50 per share and he/she would be stupid to leave the profit on the floor.
- In such case, you’re required to deliver the shares which you have in your possession. So you would be getting US$5,070 (US$70 + $5,000), giving you a profit of US$336.00 (US$5,070 minus US$4,734.00 capital) less commission.
I mentioned there’s a risky way. The risky way is called “Naked Call Writing” or “Naked Put Writing” whereby you don’t actually own the shares but you sell / write the Call or Put to the market. Some broker houses do not allow you to write naked simply because it’s too risky that your losses could be unlimited. How could that be? Based on the above example, can you imagine what will happen if the stock price of Guess escalates to $60 per share?
Assuming you’ve wrote a Naked Call of GES Jul 2007 50.0 Call. Comes expiration Friday your contract will be deep in-the-money and you’re “called” to deliver 100 shares, of which you do not have. So the broker house will issue a warrant-arrest on you (just kidding). Because you do not own the shares, the broker house will buy 100 shares from the open market and immediately deliver it. Supposing the broker bought it at $60 per share, you’re required to pay the amount of $5,930 (US$6,000 minus US$70) plus commission back to the broker house.
If you have stocks on hand, you can simply write Covered Call every month and earn the money as if you’re writing a check to your ownself. Just imagine how much you can earn if you have 1,000 or 10,000 shares. But you’ve to make sure your shares are optionable, not all the shares have option associated with it mind you. You can check it for free at Yahoo Finance here. Besides, not all stocks have monthly option.
So, that’s what some of the specialists out there trying to market you the so-called method of writing check on monthly basis. Some of the irresponsible trainers do not even tell you the difference between the “Covered” and “Naked” way of writing the option. It’s always better to become a “Writer” (seller of the covered call) than a “Holder” (buyer of the call option) because you “get paid” for it
rather than pay for it.
Please comment if this article is useful and benefits you, or you still do not understand the whole process of making money by selling the option in the stock market.
Other Articles That May Interest You …
- Option Investing 101 – Part 1
- Option Investing 101 – Part 2
- Option Investing 101 – Part 3
- Options Trading: Exercise
- Options Trading: Assignment