Rolling Dice (Cautiously) on Stock Options

Anyone who likes to play craps in Las Vegas or Atlantic City has probably got a natural feel for playing with stock options.

Stock options, which give you the right to buy a specific security at a specific price at some point in the future, are considered highly speculative investments. Like gamblers rolling the dice, option buyers can double or triple their money in a matter of hours. Or they can lose it all equally quickly.

But there are also a few relatively safe ways to play the options market. The returns are not as high, but neither are the risks. And for someone who is looking for a way to generate income in today’s on-again, off-again stock market, these options strategies might be worth considering.

The simplest and safest technique is selling a “covered call.”

To do this, you must already own at least 100 shares of a company’s stock. That’s because options are sold in 100-share bundles, called contracts. Each contract gives the holder a right to buy or sell shares at a particular price by a particular date in the future.

To illustrate, let’s say you own 300 shares of XYZ Corp. XYZ now trades on the open market for $100 a share. You bought it a few years ago at $60, so you’ve already locked in a $40 per-share profit. But now you believe that the company’s stock isn’t likely to appreciate much.

You have several choices. Hang on and hope you’re wrong about the stock’s potential. Sell the stock and invest in something else. Or sell an option that gives another investor the right to buy your stock at a higher price.

Selling an option may be the most conservative approach. It gives you the ability to earn money regardless of how the shares of XYZ fare. That’s because the option buyer must pay you for the right to buy your shares. If XYZ falls in value, the option they bought expires. If XYZ gains in value, you get the price they paid for the option, plus you sell your stock for the agreed-upon price.

For example, you decide to sell an option that gives the buyer the right to buy your XYZ shares for $105 within three months. (Since you have 300 shares, you sell three option contracts.) If each option is worth $3 per share, you pocket $900 minus brokerage commissions. If XYZ is selling for $90 in three months, the option buyer is going to walk away. You keep his $900 and your shares.

If XYZ pops up to $110 within three months, the option buyer exercises his option and pays you $105 for your shares. You end up with $31,500 from selling ($105 times 300 shares), plus the $900 you earned on the option.

Had you not sold the option, you would have been able to sell your shares at the market price. And that would have earned you more--$33,000 compared to $32,400. But by selling the option, you guaranteed yourself at least a small profit either way and thus reduced your risk.

The catch: You must determine a fair price for the options you’re selling. And that’s not easy.

The value of a stock option is determined by three things: time, price and volatility.

The more time there is before the option expires, the more the option is worth. An option that expires three months from now is usually worth substantially more than one that expires tomorrow.

As for price, an “in the money” option--an option to buy at or below the price that the stock is trading now--is worth more than one that gives the buyer the right to buy stock at a higher price than what the stock is selling for now.

As for volatility, options on shares that tend to show dramatic price swings are worth more than options on shares that don’t move around much. That’s because there’s a greater chance that the option will be exercised during one of those swings.

There’s a complicated formula called the Black-Scholes method to determine the value of these combined factors. But most investors would be incapable of calculating it by hand. There are computer programs that do the calculation for you, but they’re expensive. They usually cost at least $200.

As a result, many investors are likely to go the easy route: Ask a broker for a current market price. If the going rate is enough for you to risk having to sell the stock within the option period, you tell your broker to write the option. If not, you don’t.

This approach is clearly unscientific. But if you know your own mind and what kind of return you expect from an investment, it may work just as well as the formula.

One final note of caution: Keep a close eye on brokerage commissions. This is a game of thin margins. High trading costs can wipe out your gains.