How Do Stock Options Work?

Let me pretend that ABC is at $25 and I buy it here 100 shares. How would I work a covered call? I want to sell a call at say $26. Who decides the premium? What happens to the premium if the stock goes above $26? Can I safe guard myself and have it automatically sell at say $20? What is I put a sell limit at $20 and the stock goes below $20 and then rises above $26? Would I lose twice here?

When ABC is at $25, its $26 call options are out of the money and its premium would be about $0.75. Premium is derived from options pricing models such as the black-scholes model.

Lets assume you bought 100 shares of ABC at $25 and sold one contract of its $26 Call options at $0.75. Lets work out your breakeven points and profits.

Breakeven point = $25 - $0.75 = $24.25 . This means that the position will start to make a loss when the stock goes lower than $24.25.

Static Profit = $0.75. This means that if the stock remained stagnant, you would make $0.75 as profit from the premium from the call options.

Assigned Profit = ($26 - $25) + $0.75 = $1.75. This is the profit you will make if the stock moves higher than the strike price of the call options $26 and gets called away.

In order to put a safeguard at $20, you can do what is known as a "Covered Call Collar" by buying a $20 strike price put options with the premium made from selling the $26 call options. Since the $20 put options are much more out of the money than the $26 call options, its premium would be much lower as well.

Lets assume you bought 100 shares of ABC at $25 , sold one contract of its $26 Call options at $0.75 and bought one contract of its $20 strike price put options at $0.25. Lets work out your breakeven points and profits.

Breakeven point = $25 - ($0.75 - $0.25) = $24.50. Even though you will now start to lose money sooner than if you did not have the put options in place (due to lower premium earned by having to purchase the put options), the position will stop losing any money below $20.

Static Profit = $0.75 - $0.25 = $0.50. This is the profit you will make if the stock remained stagnant all the way to expiration.

Assigned Profit = ($26 - $25) + ($0.75 - $0.25) = $1.50. This is the maximum profit you will make when the stock goes above $26 and gets called away. This is the profit you will make as long as the stock goes above $26 by expiration no matter if it had been below $20 before that or not. No losses would be made (unlike in futures).

These are just simple calculations on the Covered Call and Covered Call Collar. For more details and free video demonstrations, please refer to the links below:

This entry was posted on Thursday, April 8th, 2010 at 6:02 pm and is filed under how do stock options work. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.