The following is from a discussion I had about a new purchase; the other party is new to options. The stock was trading at $31--32 per share; it's currently at $34. The options trade I discuss has not, as of this writing, been accepted by a buyer. Since the stock price has increased, it is no longer as attractive (as valuable) to a buyer to ensure he can sell his stock for $30. This is a small cap stock and thinly traded; I'm keeping my order open in anticipation of LNN decreasing in price. If it continues to climb, I'll let it go; there's no profit in chasing diminishing returns.
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I think it would be a good idea to make some long stock picks before getting into options; without understanding how to buy a stock for long-term investment, it's tempting to use options to speculate, which is a bad idea. Just because an option pays a 10% premium doesn't mean it's a good buy! Anyway, here's information on the option order I put in today. This was a pick from Motley Fool Pro.
I've put in this trade, but it has not yet been accepted by a buyer. The stock is Lindsay Corporation (NYSE: LNN). The stock traded at about $32/ share today. I want this stock to end up as about 4% of my portfolio, which is currently about $225,000. So, 4% of $225,000 = a maximum of $9000 I can use to secure this put.
I would be happy buying this stock for $30 a share, but it wouldn't break my heart if I never owned shares, so I'm selling puts with a strike price of $30 a share. With my target allocation of $9000 in mind, that means I'm selling puts on 300 shares, which equals 3 contracts (each contract is for 100 shares, unless otherwise noted in the options chain. All orders are placed by contract rather than by share. I always double check to make sure I haven't accidently added an extra couple zeros!)
I write options in a time window of three-to-six months expiration time. That means today I'm looking at puts expiring in August, September, and December.
August $30 puts are currently paying $2.25 per share (that is, $225 per contract of 100 shares), September is at $2.95/ share, and
December is $4.70 per share.
That means the August puts will pay 7.5% ($2.25/$30),
September puts pay 9.8%, and
December puts pay 15.7%.
Puts have better payouts for longer expiration times; this is because you're "insuring" the stock for the buyer for a longer period of time. If something happens to the stock between now and, say, December, the buyer has limited his downside (he can sell at $30 a share no matter what) without limiting his upside (if the stock goes to $60, he reaps the benefits).
I've decided to write $30 puts expiring in December (the command is "sell to open"). I check to make sure I have enough cash in my account to secure the put, then click on the December $30 option (ticker +NRRXF ) in the option chain screen, which brings me to the screen for this option; it shows me the last buying and selling price for this option.
In this case, the last sale was at $4.80/ share on Thursday the 25th (today). It isn't unusual for no options to be traded for days on a small stock! The current bid for this option is $4.70/ share. The ask is $5.10/share; at least one person is willing to write this option for $5.10/share.
I place my own order; "sell to open three (3) contracts of +NRRXF, limit at $4.80/ share." That's $480 per contract, for a total return of $1440. Currently, that order is just sitting waiting for someone to accept it--like a stock order that has not yet reached your limit price.If someone accepts the contract, here's what will happen; my account will be immediately credited $1440. $9000 will be frozen, unavailable for withdrawal or stock purchases. However, it will remain in my money market account.
At the options expiration date, there are just two possibilities; either the stock will be selling at or above $30 in the open market, or it won't. If the stock is selling above $30/share, nothing happens; the option expires worthless to the buyer (except for the peace of mind it brought him) and I keep the options premium. If the stock is selling below $30, I still keep the premium, and the $9000 that was securing that put will be used to purchase 300 shares (3 contracts) of the stock. I don't have a choice there; if the stock has dropped to $5, I'm still obliged to buy it at $30.
The options premium can be considered as income, or as subsidizing the purchase of the stock. If the option expires, I'll pay $30 per share, but I was paid (hopefully) $4.80 per share; my net cost per share is $25.20 per share--compare this to purchasing out-right today for $32! The downside is the potential opportunity cost; if LNN jumps to $60 by December, I'll kick myself for not buying at $30. This is what I was talking about when I recommended using options with an investment mindset, rather than for speculation. It's important to know the company you're writing options on, so a significant change in share price won't be a surprise (barring a black swan event).
