Options trading can provide investors with a strategy to generate extra income, hedge risk or speculate for higher profits. It can be overwhelming at first to understand options but once you understand the characteristics of options, it becomes easier.
Dividend investors, who seek investment income, can often increase their income with covered calls. In fact, many dividend ETFs employ covered calls as part of the income strategy for many of the income ETFs. One example is the BMO Covered Calls Canadian Banks ETF.
What Are Options?
Even though you trade options like stocks, options are not securities like stocks, they are considered derivatives as their value depends on another asset.
An option transaction takes the form of a contract representing a fixed number of shares (usually in blocks of 100 shares), a fixed price on the underlying stocks known as the strike price and an expiration date. Like stocks, there is also a buyer and a seller.
In the options world, specific terms are used to represent the various contracts such as call options and put options. A call option will have a bullish buyer and a bearish seller while being the opposite on a put option with the buyer being bearing and the seller being bullish.
Benefits of Options Trading
You can approach options trading as a strategy for your portfolio or you can trade options for speculations and profits.
With speculation, you make profits by investing small amount since you only pay for the premium.
From a portfolio management perspective, options can help you:
- Protect your profits from a decline in stock price
- Generate additional income (covered calls)
How Call Options Work
A call option is an option contract to purchase a block of shares at a set strike price with a defined expiry date for a premium (the cost of the option contract).
The premise of a call option for the buyer is to see the stock price go higher than the contract’s strike price. At which point the buyer can exercise the option to buy the shares at the strike price and immediately have a profit on the shares (on paper).
If the share price of the stock doesn’t go over the strike price of the contract, the buyer doesn’t have to exercise the option contract and loses the premium paid for the contract. It’s also known as being out-of-the-money.
A naked call is when the seller of call options doesn’t own the underlying shares. It increases the risks on investor.
Call Option Example
When an investor buys one call option on Royal Bank, we have the following parameters.
- Royal Bank Stock Price: $130
- Call Option Strike Price: $145
- Expiry Date: 1 month
- Premium: $0.22 per share
Say in 1 month from now, the Royal Bank stock increases to $160, and the buyer exercise the contract. The buyer has an immediate profit, on paper at least. If the stock price for Royal Bank stays under $145, the buyer of the contract doesn’t have to follow through and loses the premium.
[(RY Current Price – RY Buy Price) – (Put Premium)] × Number of shares or units
Profit = [($160 – $145) – $0.22)] × 100 = $1,478
How Put Options Work
A put option is an option contract to sell a block of shares at a set strike price with a defined expiry date for a premium (the cost of the option contract).
In the case of a put option, the buyer wants to see the price go below the strike price while the seller doesn’t. If the price goes below the strike price, the contract holder can exercise the options to sell the shares usually with the intent to also buy them at the lower price to make an immediate profit.
Same as with a call option, if the stock price stays above the strike price, the contract holder doesn’t have to exercise the option and loses the premium paid.
Put Option Example
When an investor buys one put option on Netflix, we have the following parameters.
- Netflix Stock Price: $665
- Put Option Strike Price: $600
- Expiry Date: 1 month
- Premium: $14 per share
Say in 1 month from now, the Netflix stock drops to $550, and the buyer exercise the contract. If the buyer has the shares and paid $500 for them, the buyer protected some of his profit. The strategy is to hedge risk and the math looks like this.
[(NFLX Sell Price – NFLX Purchase Price) – (Put Premium)] × Number of shares or units
Profit = [($600 – $500) – $14.00)] × 100 = $8,600
Income Strategy with Covered Calls
A covered call is simply a clarification of a call option where the seller of the call option holds the underlying shares. If the buyer of the contract were to exercise it, the seller has the shares and can simply sell them.
The income strategy with covered calls is where long term investors seek to generate extra income from the call options premium. As a dividend investor, you usually hold long term positions in the best dividend stocks that grow their dividend and these holdings could be used with covered calls.
Take the call option example with Royal Bank. In the case where the price stays under $145 and the buyer doesn’t exercise the contract, the investor selling the call options has the premium of $200 ($2.00 x 100) and keeps the shares.
In that case, you can say the investor generated an extra $2 per share on his investment. When it comes to dividend investors, and you add it to the dividends you receive from Royal Bank, you have two sources of income from your shares.
What’s the risk? It’s more of an inconvenience than a risk. When the strike price is higher than your purchase price, so you realize your gains and if you want to hold the stock again, you have a couple of transactions to get back there.
Below are the options available for Royal Bant TSE:RY 3 months out as an example.
Where Can I Trade Options in Canada?
All of the Canadian big banks have support for options trading with their online trading platform and many of the independent online brokers will have support as well.
However, if you plan to execute covered calls, you can do so with most Canadian online brokers except for Wealthsimple.
What is an option strike price?
The strike price is a critical parameter of options trading. It identifies the stock price of the underlying security the contract is bound to.
For call options, the strike price is the price at which you can buy the stock. For put options, it’s the price at which you can sell the security.
The strike price, along with time, is used to determines the premium, or value, of an options contract.
What are American-style options?
American-style options are the most common and allows for the contract to be exercised at any time up to and including the expiration date.
What are European-style options?
European-style options, on the other hand, can only be exercised on their expiry date.