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Monday, September 04, 2006

How Call Options Work?

In my last post, I mentioned about call options. So the question is what exactly are call options? Call options basically give you the right to buy the underlying stock at a certain predetermined price by a certain date. The predetermined price is referred to as the strike price while the date by which the rights must be exercised (or they expire) is referred to as the expiration date.

Thing to know is that you can purchase or sell call options. So far, I have only sold call options and that too only if I own a stock. These call options are referred to as covered calls since I already own the underlying stocks on which I have written call options. If you sell call options on a stock which you do not currently own, its referred to as naked call options. Selling naked call options can be very risky because if the underlying stock rises in price substantially above the strike price, you as a seller will still have to provide those shares at the strike price, even if that means that you have to first buy the stock at the substantially higher current market price. That's why I don't indulge in naked calls.

To see how call options work, consider an example. Assume I sell 10 contracts (each contract is equal to 100 shares) of call options on Microsoft on Sept 1, 2006 with expiration date of September 15, 2006 (options typically expire on the 3rd Friday of the month). Assume the stock is currently selling at $25 while my strike price is $30. Assume that the premium I get for writing 10 contracts is $0.20/share. So when I sell these options, I get $0.20/share * 1,000 shares = $200 minus say $10 for the brokerage commission (and of course, any taxes that I will have to pay on it), resulting in net proceeds of $200 - $10 = $190. So if by Sept 15, Microsoft stock stays below $30, I will be able to keep my existing 1,000 shares and in addition, get to keep the proceeds ($190) from selling these call options. Of course, if the stock price goes at $30 or above, then I will have to sell my shares at $30 to the buyer of the call options. So I will get $30 * 1,000 = $30,000 minus any brokerage commissions, taxes and other miscellaneous fee. In addition, of course, I still have $190 that I got by selling these call options in the first place.

So if I was planning to sell the Microsoft stock any ways at $30, then by selling call options on it, I can get an addition amount for it, assuming the stock price rises above the strike price. Of course, if the stock price of Microsoft stays below $30 by the expiration date, I get to keep all the net proceeds from call options -which isn't bad. On technology stocks, personally, I consider these proceeds as dividends and keeps my interest on these stocks.

A good article on options was published recently at theStreet.com; see the link below:

Options

As always, a final disclaimer: the purpose of my writings or this web site is not to give any financial advice nor make any recommendations. This site is just a blog of my activities, interests and thoughts. Trading options and stocks can be very risky, so you need to exercise your judgment and seek competent advice before investing in such instruments.

Labels: investing; invest

posted by Ruby @ 6:48 PM

1 Comments:

At 1:40 PM, Anonymous said…

Good to know about these options.

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