How to create an extra dividend in the stock market with call options

Susan
By Susan April 18, 2012 09:06

How to create an extra dividend in the stock market with call options

 

 

A call option is the right, but not the obligation, to buy a stock at a certain price. To a stock owner, this means a guaranteed income! And to a buyer, it means the possibility of netting a tidy sum.

With a call option, the buyer pays for the right to buy a stock at a certain price, at a certain point in time. Let’s say that a person believes a stock will be €5 in three months’ time, they can buy the right to buy that stock at €4 instead. Of course, if the stock is only at €3.50 at that stage, this right is worth nothing – and they don’t have to buy the stock since they are in no obligation to do so. On the other hand, if the stock does actually hit €5, they are able to buy it for less than the market price!

 

How does a call option work?

 

A call is an agreement regarding two things:

– a strike price: the locked-in price of the stock,

– a strike date: the agreed-upon date at which the sale will happen, if the buyer decides to go ahead and buy the stock.

And this agreement has a price: to lock in the price of the stock, the buyer agrees to pay a premium, whether or not they buy the stock in the end.

So the buyer buys two things:

– the right to lock in a certain price

– and then the actual stock at that particular price, if they still want to buy it at the strike date.

So, in a nutshell, this is what a call option is: Person A buys the right to buy a stock at a certain price from Person B. The right to buy the stock at a previously agreed upon price is a call option. The price that the potential buyer pays to lock in the stock price is the premium.

 

Who would want to buy a call option?

 

Let’s say a stock is looking good, the company offering that stock is healthy and doing very well.

A buyer might be interested in that stock, but for whatever reason (they don’t have the money right now to buy the number of stocks they want, they want to wait and see, or they have some other strategy), they decide not to buy the stock right now.

At the same time they believe that there is a high probability that the stock will go up, and they have a mind to buying it in the future. To mitigate the disadvantage of buying the stock later for more money than if they bought it today, they can resort to calls. On the other hand, if the stock doesn’t actually go up in price, they may not want the stock at all! As a result, they just want the right, but not the obligation, to buy the stock at a certain price.

Their problem is that they don’t know how much the stock will cost when they actually get around to buying it. What if it skyrockets? Wouldn’t you be irritated to have to shell out €17 for a stock that only three weeks ago was trading at €10?

But for whatever reason you couldn’t or wouldn’t buy the stock three weeks ago. And you have to pay an extra €7 for not buying the stock earlier – unless three weeks ago you had the good sense of buying a call!

So the potential buyer enters an agreement with a person who holds that stock. The stock is currently trading at €10. They decide to pay the stockholder €1 to be able to buy the stock at €14 in six months’ time.

 

And what’s in it for the stockholder?

 

The stockholder makes both an income: the price of the premium; and a profit: if and when the potential buyer buys the stock from them, the buyer will buy it at a price higher than the stock is currently trading.

If I hold a stock that is currently trading at €10, and I sell a call option to sell that stock at €14 at a later date, on the condition that the potential buyer pay me €1 today, I have made:

– €1 (price of the premium, for securing the stock price),

– and €4 (difference between the current price of the stock and the price at which I will later sell it), if the buyer decides to exercise the option.

I have earned €5.

If the buyer decides to not buy the stock, I don’t make a profit, but I still have the income from the premium – and I still own the stock.

When I explain this, the overwhelming reaction is one of “But this sounds too good to be true!”

And in a way it is!

 

Whatever happens, you cannot lose money

 

But you might lose out – on a bigger profit.

This happened to me in 2009. I owned stocks in the emerging market index and they were trading at €33 or  €34. I sold a covered call to sell them at €35.

And then the index went up way past that. The person who bought the stock off me was very happy, as, by spending the price of the premium, they were now able to buy the stock below market price.

And I lost out on the profit I could have made by selling the stock at the higher market price.

But I had still made some income, and a profit… Not too bad!

For the buyer, call options are a means to potentially get a stock at a lower price than what the market is demanding, and for the seller, they are a means to guarantee they will earn money.

Now how do you actually use call options? I will talk about that next week in a second post. And I will also explain what you should never, ever do with a call option…

 

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Susan
By Susan April 18, 2012 09:06