What is a stock option?
Updated: Jan 20, 2021
First, let me start by letting you know that I am not a stockbroker and stock options involve a level of risk that should be thoroughly reviewed with your registered investment adviser or a broker-dealer and your tax accountant. As a matter of fact, before you can trade options you must be approved to do so by your brokerage institution and will be required to read Characteristics and Risks of Standardized Options which will provide you with extensive material to consider before buying or selling your first options contract. This discussion is for educational purposes only and not investment advice and will cover some of the basics of options and one of the strategies I have used over the last 30 years to enhance the returns on my portfolio. Specific securities are mentioned for informational purposes only and are not presented as investment advice.
A stock option is the right to either buy or sell a specific amount of stock at a fixed exercise price before the specified expiration date. Each stock option contract covers 100 shares of the underlying stock. An option that gives the right to buy a stock is a call option, an option that gives the right to sell a stock is a put option. The option ceases to exist at the specified expiration date. Let us look at a real-world example to help clarify some terms.
Without going into the details of cryptocurrency, I would like to share a stock purchase and a series of options trades that allowed me to leverage an investment theory I had regarding Bitcoin. By now everyone is familiar with the success of Bitcoin and while searching for a way to participate in what I thought would be a rise in its value I discovered Riot Blockchain, Inc. (RIOT), a company involved in Bitcoin mining. Below is a custom chart for the stock RIOT over the price of Bitcoin for the periods of my trades.
You can email me if you would like more specifics but for now, I will review the series of trades I made and explain the terminology of options as I go. As a reminder, although these are actual trades, please remember I have been doing this for a while and I would highly encourage you to paper trade and get educated on the risks of options or work with a financial advisor/broker if you decide to use these strategies.
The table below shows my trades from August 6, 2020, to November 19, 2020:
I will cover one options strategy and a few different exit strategies as I walk you through my trades. I first acquired 1,000 shares of RIOT stock on August 6, 2020, for a cost of $4,360 or $4.36 a share. I then used a strategy called covered call writing to sell the right for someone to buy my 1,000 shares of the underlying RIOT stock for the strike price of $6.00 a share by the expiration date of September 18, 2020. In option shorthand I sold 10 - CALL (RIOT) RIOT BLOCKCHAIN INC SEP 18 20 $6 (100 SHS), remember each option controls 100 shares of the underlying stock. The option premium for this trade was $.85 per share or $85 for 1 options contract (controlling 100 shares), so my trade of 10 contracts ($85 x 10 = $850 less commission) yielded $843.12.
So, what just happened? I purchased 1,000 shares of stock at $4.36 per share for a total cost of $4,360 (I use Fidelity and pay no commission on stock trades). I then sold someone the right, netting $843.12, to purchase my 1,000 shares of stock from me for $6.00 a share by September 18, 2020. If the stock is below $6.00 a share by that date, the option expires, and I keep the $843.12. If the stock is above $6.00 a share then the option will be exercised, and I will have to sell my shares at the strike price of $6.00. If the stock goes to $100 by September 18th, I must still sell it for $6.00 a share. In this case, selling a stock I purchased for $4.36 a share a little over a month earlier for $6.00 would have been a good payday. Remember I purchased 1,000 shares for a total cost of $4,360 and sold 10 covered call options for an additional $843.12. At a sale price of $6.00 a share, my proceeds would be $6,843.12 on a cost basis of $4,360 yielding a return of 56.95%. Sadly, the stock closed at $3.05 a share on September 18, 2020, and I was comforted by the fact that I was able to keep the $843.12 that the sale of my now expired covered call option contracts yielded.
The net effect of this set of trades on September 18th lowers my cost basis in my RIOT stock. I purchased each share for $4.36 and received a premium of approximately $.84 a share for my covered call trade effectively lowering my basis to $3.52 a share. Rather than selling the underlying stock for a loss, I continued to track the relationship between RIOT and Bitcoin. On 10/12/2020 I opened another covered call this time selling 10 - CALL (RIOT) RIOT BLOCKCHAIN INC NOV 20 20 $4 (100 SHS) at $.40 per share or $40 for 1 option contract, so my trade of 10 contracts ($40 x 10 = $400 less commission) yielded $393.13.
In the September options trade, I allowed the option to expire and collected the entire premium. If you look at the graph between RIOT and Bitcoin prices, you will notice that RIOT appears to lag the rise in the price of Bitcoin starting around October 26th. Not wishing to miss a potential move higher I rolled my position, with the underlying stock trading at $4.10 (in the money), I purchased 10 - CALL (RIOT) RIOT BLOCKCHAIN INC NOV 20 20 $4 (100 SHS) to close out my November covered call position for a net cost of $330.36 and a gain of $62.77 and rolled into (sold) 10 contracts of the CALL (RIOT) RIOT BLOCKCHAIN INC DEC 18 20 $5 (100 SHS) options. Net proceeds on this covered call sale came to $423.13. This transaction not only provided me another month of time value it also allowed me to increase the strike price to $5.00.
The components that allowed me to walk away with a profit on a relatively flat period of stock performance and roll to a higher strike price a month in the future are the two components that combine to determine the option premium, intrinsic value, and time value. The intrinsic value reflects the amount, if any, by which the option is in the money, above the strike price for a call option or below the strike price for a put option. An option that is out of the money would have an intrinsic value of zero. Time value is whatever the premium of the option is in addition to its intrinsic value. Time value is that part of the premium that reflects the time remaining before expiration.
As I complete this post on November 20th, RIOT is trading at $6.19. Should it remain above my $5.00 strike price on December 18th the stock option will be exercised and called away from me. From the table above you can see that the gains from this hypothetical sale highlighted in yellow coupled with the options premiums collected would come to $1,969.02 on my initial $4,360.00 cost basis for the stock, a return of 45.16%. These trades were conducted in my Roth IRA, but had they not been in a tax-advantaged account, given that these trades were completed in 134 days these would be treated as short-term capital gains. Again, speak with your tax accountant to understand the implications of all your investment decisions.
The covered call can be useful in tax-advantaged accounts where you might otherwise pay taxes on the premium and capital gains if the stock is called. A covered call can be a good strategy to generate income when you already own a stock and do not expect the stock to rise significantly before expiration. We will cover another strategy in a future blog. I will be using actual trades from the same stock (RIOT) to explain these as well. Stay safe and have a good holiday! See you soon.