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Probably the easiest option to trade and understand is the “covered call option”.
Let’s first review the fact that in order to trade any type of option you first must get your broker’s approval to trade options.
Approval isn’t automatic and each brokerage firm has different requirements based on your net worth, assets with the firm, income, risk tolerance and option trading experience. There are various levels of approval depending on the factors just mentioned.
Generally low level approval is all you will need to trade covered calls.
In this example we are going to sell a covered call on Apple stock (AAPL)
When trading covered calls, you either already own the stock in your portfolio or execute a Buy/Write option which means you buy at least 100 shares and then place a covered call on those shares.
When you sell and option, you receive a premium for that option. That premium will depend on the volatility of the option market measured by the VIX. The foremost measure of fear is the Volatility Index ("VIX").
It measures the prices investors are willing to pay for options that insure the value of their stock holdings. When the VIX trades around 20, it means investors are scared. When it's above 25- 30, they are completely spooked.
Each covered call option contract equals 100 shares, so if you sell 2 contracts you must have at least 200 shares of that stock.
In our example we own 100 shares of Apple (AAPL)
Covered Call on AAPL
Sell to open 1 contract (100 shares) of Apple (AAPL) for April 15 Strike price of $105 @ 1.59.
Let say we purchased Apple back a few weeks ago at $98, in this example we are willing to sell our shares in apple if it reaches $105 by April 15, 2016. We receive $1.59 in premium per shares for a total of $159.
If the price stay below $105 by the expiration date of April 15, we keep the shares of Apple and the premium and any dividend we might have received during the period.
If the shares are trading above $105 our shares will be called away, which means we have to sell our 100 shares at $105.
The strategy here is to place covered call options on stocks that we feel will stay flat or decline slightly over a pre-defined period of time, that being 90 days or less.
If the stock starts losing considerable money, you always have the ability to reverse the option contract by buying it back before expiration date or before it is called away.
To reverse an option trade in this case we would place a “Buy to Close” on AAPL
Most likely you will end up paying back more than you received when you sold the contract, taking a loss on the deal.
Feel free to ask any questions you like.
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Daniel F. Iuculano, AAMS CMFC
Accredited Asset Management Specialist
Chartered Mutual Fund Counselor
