I had encountered the idea of using options for passive income from online discussions and acquaintances. Being a passive income advocate, I would naturally be interested in this, and decided to find out more.
What Are Options?
Options are a type of derivative financial instrument, which derives its value from an underlying security. An option is a contract which gives the holder the right, but not the obligation, to exercise a transaction, with the other party.
There are two types of options: call and put options. A call option is a contract which gives the holder the right, but not the obligation, to buy a set number of shares at a set price (or strike price) within a given period. A put option is the opposite, i.e., a contract which gives the holder the right, but not the obligation, to sell a set number of shares at a strike price within a given period.
Since options are contracts, there are generally two parties involved: the buyer of the call (or put) option and the seller of the said option. Buying the option involves a premium to be paid upfront to the seller, who sells or writes the option.
There are three main variables in an option: the premium, the strike price and the expiration date. The premium would be the price to pay for the options contract, but this amount could go up or down depending on the market. The strike price is the agreed-upon price to purchase the underlying security, while the expiration date is the end-date of the option, after which the contract would either be exercised or become a worthless piece of paper.
Do note that there is no options trading on local counters, only overseas securities (especially in the United States).
Call Option Example
Let us take two parties, B (buyer) and S (seller), and share counter X, with a current share price of $100. B bought a call options contract from S that enables him/her to buy 100 shares of X at $120 in a month’s time from S, at a premium of $5 per share (for a total of $500). Assuming B held the options till the expiration date, we shall see the following three scenarios then:
Scenario #1: Share price of X hits $110 – Since the current share price is less than what B can buy for, he/she decided to let the options lapse (and S gets to keep his/her 100 X shares and the paid premium of $500).
Scenario #2: Share price of X hits $140 – Since the current share price is more than what B can buy for, B decided to exercise his/her option and S is obliged to sell B 100 shares of X at $120 each. B saved [($140 - $120) x 100] - $500 = $1500. For S, his/her gains are the $500 premium and the difference between $120 and his/her initial purchase of X, if any.
Scenario #3: Share price of X hits $120 – Although the current share price and the strike price is the same, B is very likely not to exercise the option as the total cost per share is $125 instead, with the $5 being the premium paid for each share.
Put Option Example
Using the same settings as the previous section, with share X currently at $100, B bought a put option from S at a premium of $5 per share (for a total of $500) to sell his/her 100 shares of X at $80 to S at the expiration date. Assume B held the options till then, and visiting the three scenarios:
Scenario #1: Share price of X hits $90 – Since the current share price is more than what B can sell for, he/she decided to lapse the option (and S gets to keep the $500 premium and need not buy the X shares from B).
Scenario #2: Share price of X hits $60 – Since the current share price is lower than what B could sell for, B decided to exercise the option and S is obliged to buy the 100 shares of X from B at $80 each instead. B saved [($80-$60) x 100] - $500 = $1500. For S, his/her potential loss would be [($80-$60) x 100] - $500 = $1500, since he/she could get a better price in purchasing shares of X from the open market.
Scenario #3: Share price of X hits $80 – Although the current share price and the strike price is the same, B is very likely not to exercise the option as the total selling price per share is $75 instead, with the $5 being the premium incurred for each share.
American-Style And European-Style Options
To make things more complicated in the world of options, there are two different option styles out there, namely American and European. American style options could be exercised any time before the expiration date, while European style ones can only be exercised on the expiration date itself. The naming of the styles does not mean that they are carried out at those locations, rather it is a form of describing them. Thus, not all American securities practice American style.
So Where Does The Passive Income Part Comes In?
Typically, the basic source of passive income comes from the premiums of selling the options, which is done by S in the above scenarios. Provided the options were not exercised, we could just sell options non-stop and get the premiums. However, things are not so simple as the other side (i.e., B) may exercise the options depending on the current price of the underlying security, and the previous premiums earned may go up in smoke.
As we all know, the markets (and price) are unpredictable in nature. While some options traders rely on technical analysis to forecast price movements, others would employ some strategies in preventing losses from options being exercised by the holders, and this involves selling and buying options at the same time. There are many strategies around, and they have interesting names (“iron condor”, “iron butterfly”, “long strangle”, etc.).
The Bedokian’s Take
To a beginner, all these may look intimidating. An acquaintance of mine who dabbled in options mentioned that it’s just like learning a new skill: learn, get one’s feet wet, and soon one will get the hang of it. In my opinion, it depends on the comfort level of the investor himself/herself, and whether he/she is open to options trading to augment additional income. Options trading do require some time taken to monitor the markets and prices, sometimes on a regular basis, akin to active management.
If you are interested, and if you already have an investment portfolio, treat options trading separately in a trading portfolio (as I had stated here). Any gains from it could be funneled back to your investment portfolio’s cash component as a war chest or be used to fund your day-to-day expenses if required.
For passive investors, options trading could be tricky, but there’s a way to go about it, which I would share in the next post (or maybe the next, next post, see how it goes).
Ultimately, and following my standard advice, it is a “know what you are doing” thing for options. You have the right, but not the obligation, to follow my take.