What is an “option”?
Introduction to Options
When purchasing an option – you are given the right to buy an agreed upon amount of shares of a particular company on or before an agreed upon date assuming the price reaches the breakeven price (Strike Price) as specified in the contract.
When you sell an option – you now have an obligation to fulfill the terms of a contract to sell an agreed upon amount of shares of a particular company at a specified price on or before a given date assuming the contract is exercised.
Calls are the right to buy, whereas puts are the right to sell shares. Puts, much like short selling make money on a spread. In this case you can purchase shares at the lower market price and sell back at the higher locked in price leaving the difference which is pure profit. Remember each contract is for 100 shares, so when looking at the premium - $1.3 - that’s actually per share; you need to multiply that figure by 100 to figure out what the premium is, which is actually $130 for that contract.
Using Company XYZ as an example company, the Tangible Book (tangible meaning that they are the hard assets or physical assets) value is roughly $15.15 and my cost basis is roughly $10.85 (that is the average amount paid for one share). The tangible book value by its simplest definition is the Current net assets – the value of the assets if you liquidated at this point in time. My cost basis is roughly 28% under the Tangible BV which is for these purposes my Margin of Safety. This stands as a fairly safe investment and is one I would wish to hold for the long-term – the idea being that over this time the market will eventually come to its sense, and value the company for at least what it could get if it were liquidated.
It has been clear that there is still a lot of uncertainty in this market and the prices of the general market are reflective of that, so to protect for any potential downside risk you can use options. There are strategies for everything, and many are very advanced, but I want to show you how simple and yet effective they can be.
“Collar:” Long the call & Short the put. (Sell the call & buy the put).
As you can see in the Table above, we can set our range with a floor at $11 which was roughly the cost basis and a ceiling at $13. By purchasing the put we have given ourselves downside protection from the market, but if you have been paying attention you have already realized this costs us some money upfront. This upfront money is paid for by the premium that we get from selling the call. While this would limit our profit to 23%, it is a gamble we are willing to take. If the stock were to stay in a tight range and trade no lower than $11, but no higher than $13, the options would never breakeven and would therefore expire out of the money.
If we had only just sold a call – selling a covered call – we would have left ourselves exposed to downside risk, with only the $150 in premium we collected to offset any losses we may incur. However, should the stock trade in a close range again, we would have collected $150 over our initial investment of $3300 which would give us roughly a 4.5% gain. This has become a popular strategy for people who are looking to collect a premium while holding a stock that has long-term potential but is currently in a sideways pattern.