Monday, October 30, 2006
Stock Options
Stock options have been all over the news because of fraud by executives via stock options.
Stock options all you to own the option or choice to buy stock at a set price later on in time. It’s like putting 5% down on a home so that you have the right to buy it a year later. If you don’t buy it a year later, you’ve lost the amount you spent. But if the value of the home goes up 8% then you can exercise the option, buy the home, and sell for a 60% profit on your investment.
Options give you extreme leverage on your money. When you buy options, you are buying them from someone who has written calls on their stock. These are sold in 100 share lots. The seller has chosen to sell the options for their set price and allow the buyer to purchase at that price.
Here’s an example.
I own 100 shares of Wal-Mart and I think the price of Wal-Mart stock will not move up or it might even lose value. I think that the value per share will be absolutely stagnant until January 2007 when 4Q numbers come out. In order to make some money with my shares, since I don’t think they will gain value, I write what are called covered calls.
Wal-Mart costs $50 a share. I’ll sell the option to buy my stock at $52.50 anytime before the third week in January for just $.39 a share. Since I have 100 shares, I can make $39 even if my investment goes no where.
For an investment of $39, the buyer essentially controls my shares until January. I cannot sell my shares because I have an open option on them. If Wal-Mart goes up to $55 per share then the buyer can buy my shares from me for $50 because he bought the options, this results in a net gain of $461 on my 100 shares.
I gain $39 from the sale of the options no matter what, but I missed out on the $5 gain on each share. If Wal-Mart stock stays at $50 then the purchaser of my options won’t exercise his option. He can buy the same stock on the open market for $50 a share so why pay $52.50 from me? Even though Wal-mart neither went up or down in value, I pocketed $39 from my shares of stock. Pretty cool huh!
Selling covered calls on your shares always gives you an instant reward of the cost of the option. However, if the price of the stock goes up, you could lose out on potential gains.
It’s another gamble in the world of investing. I would recommend selling covered calls to earn additional returns on your stock if you don’t think that the shares will be going up in value any time soon. The opposite can be done if you are currently short on a stock, you can sell shorts if you don’t think the price will drop.
Tomorrow I will highlight how executives have been cheating investors through stock options and how you can get the most from your options.