How to Pick the Right Stock Options

How to Pick the Right Stock Options

One of the main attractions that gets spruiked about options is their leverage. The premium involved in buying an option is typically only a fraction of that needed to buy the underlying shares, so a trader can gain exposure to a much larger position.

You do this by buying multiple contracts. As an option contract is typically for 100 shares, you could, for example, buy 10 option contracts (giving you exposure to 1,000 shares) for a similar cost to buying 100 shares outright.

If the share price goes for a run, this could pay off nicely…in theory. You’ve gained exposure to 1,000 shares, rather than buying 100 shares, meaning your profits, and return on equity, should be much higher.

But while the theory sounds attractive, it’s much harder to do than it looks. For a start, the share price has to get above the option strike price, plus the premium paid to buy the option, before the trade can pay off.

And then there’s the issue of time. The share price has to do all this before the option expires. The person who you’re buying the option from is usually a professional ‘market maker’ whose job it is to know what an option is worth.

It’s unlikely that a market maker is going to quote a price that puts the advantage on your side. That’s why, after trying unsuccessfully to make money from buying options, some investors decide to take the other side of the trade — that is, write options.

Taking the other side

If you’ve bought a call option before, you know that it gives you the right to buy the underlying shares at the option’s strike price up until the option expires. For writing the option — that is, selling it to you — the market maker receives a premium.

If the option expires without being exercised, they keep the premium. And then they do it all over again — that’s how they make their living.

But writing a call option comes with obligations. If the call option is exercised, the market maker must hand over the shares to the option buyer at the option’s strike price. It becomes like a normal share transaction — the shares must be handed over in two days.

For private investors, it’s imperative that they already own the underlying shares before writing call options over them. If they don’t own the shares, and the option is exercised, they’ll be scrambling in the market to buy the shares to fulfil their obligation.

If the share price spikes, this could lead to a massive loss. That’s why you should only consider writing call options — that is, taking the other side of the option trade — if you own the underlying shares.

An option buyer typically thinks in terms of actual gains. That is, how much they’ll make if the share price gets to ‘X’. But writing call options requires a different mentality.

The most you can make from writing the option is the premium you earn. Because of that, you need to think about it in terms of income. Writing call options regularly over shares you own can be a great way to spruce up your income beyond the regular dividend payments.

But…which option to write?

When you write a call option over your shares, there are two main parameters you need to navigate. The first is the option’s strike price — the price you agree to hand your shares over at if the option is exercised.

If you’re not prepared to sell your shares at the strike price, then you don’t write the option. The higher the option strike price above the share price, the less it will be worth. Because it has less chance of being exercised, the option buyer will be prepared to pay less for it as a result.

This relates directly to the premium you want to generate. Option writers will often chase higher premiums, thereby writing options at lower strike prices. But this is the wrong way to go about it. You need to choose the strike price first, and only write the option if you’re satisfied with the premium it generates.

The second thing is time. When you choose a strike price, you need to have a belief about what the share price will do up until the option expires.

As you’d expect, this is the hard bit. And it’s why most of the options that are traded have expiries of less than three months. The further out you go, the harder it is to estimate where the share price might be.

It’s important to understand, though, when you write a call option, you don’t need to anticipate what the share price will do exactly. Just that it will be below the option’s strike price at expiry. If you get it wrong, and the share price rallies above the strike price, you can always look to buy the option back.

Another thing to consider is tax. Before writing a call option, you need to determine if you’re liable for any capital gains tax in case the option is exercised and you have to hand over your shares.

Writing call options can be a great way to generate income. But you need to consider both the strike price and time until expiry before considering the premium you might earn. Only write a call option at a strike price you’re prepared to sell the shares at. And choose your expiry month based on what you think the share price will do within that timeframe.

Matt Hibbard,
For Markets and Money

Matt Hibbard

Matt Hibbard

While many investors chase quick fire gains, Matt takes a different view. He is focused on two very clear goals. First: How to generate reliable and consistent income in a low-interest rate world. And second, how you can invest today to build wealth over the next 10–15 years.

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