Stock options are financial derivatives and those are usually seen as complex and very risky modern day invention. We’ve all heard Warren Buffet calling derivatives the financial weapons of mass destruction.

Those images dominate even within the financial industry, let alone the general public in probably any country in the world. No need to emphasize how much they apply to a country like Croatia where financial markets are almost nonexistent.

So, are financial derivatives a modern day invention Wall Street uses to scam the little guy? The term “derivatives” is very broad so some maybe are but stock options are certainly not.

 

History of option contracts

The first mention of option contracts actually traces back to Ancient Greece. Famous philosopher Aristotle in his work “Politics” told the tale of Thales of Miletus, a philosopher and mathematician who made a fortune by snapping up options on the right to use olive presses right before a strong harvest.

Trading option contracts was a common event on the Antwerp bourse during the 16th century. Option trading flourished during the “Tulip mania” in the 17th century Netherlands and featured a sophisticated clearing process.

Clearly option contracts are not a modern development and their existence arises from the fundamental process of exchange in markets. And Warren Buffett uses options a lot. Brief google search will provide plenty of data points.

 

Stock options

Stock option is a derivative which means the price of the option contract is linked to the price of the underlying stock.

Option contract gives the buyer the right, but not the obligation, to buy (call option) or sell (put option) a stock at an agreed-upon price within a certain period of time.

On the other side of the transaction is the option seller who has the obligation to sell (call option) or buy (put option) a stock at an agreed-upon price within a certain period of time.

By combining those 4 basic positions with different strike prices and different expirations, options provide a nearly endless array of strategies.

It might sound confusing now but we’ll explore 3 simple strategies easy to understand and use.

 

Strategy 1: Protective Put

Position is created by owning stock and buying put options which act like an insurance, they cost a premium but reduce the risk.

Say you own 100 shares of Apple which currently trades at $170 and you want to reduce the risk. You can buy a say $150 put option expiring in say 3 months. That option gives you the right to sell your Apple stock at $150 at any moment during the next 3 months which limits your downside risk to $20.

You can choose any strike you like, even the one above the current price. You can also choose the expiration which may be anywhere from a week to a year. Obviously the $200 put will cost more than the $100 put and the one expiring in a year will cost more than the one expiring next week.

Current AAPL option prices (November 17th):

$150 put expiring on December 15th costs $0.39. The same strike expiring on April 20th costs $3.43.

$170 put expiring on December 15th costs $3.28. The same strike expiring on April 20th costs $10.38.

The best thing about the strategy is you don’t have to wait till expiration. If the stock falls down, you can sell the put option at a profit and still hold the stock.

 

Strategy 2: Covered Call

Covered call strategy involves owning stock and selling call options on that stock which generates income.

Let’s say you own those same 100 shares of Apple from the previous example. They trade at $170. You may decide to place a sell order at $200. But instead you can sell a $200 call option that obliges you to sell at that price but for which you will receive a cash premium. You actually get paid for having a sell order.

As with the put options, you may choose any strike and any expiration that fits your view on the stock.

Say you decide to sell AAPL $200 call expiring in April. That option is currently trading at $2.40.

So for every AAPL share you own you immediately receive $2.40 and take a 5-month obligation to sell at $200. Your basic idea was to sell at $200 anyways so this strategy does not have any downside to it.

Regardless of whether the stock goes above $200 or not, you keep your $2.40 anyway.

Combining strategies 1 and 2 will result in a very conservative collar position where you pay for the downside protection by giving up on the gains above your short call strike. That is exactly what I do for one of the funds I’m running.

 

Strategy 3: Cash-secured put

This strategy allows the investor to be paid a premium for the obligation to buy a particular stock at a certain price.

Let’s go with Apple again but this time you do not own a stock. It trades at $17O and you’d like to try to buy it cheaper – let say at $150. You could place a buy order and wait or you can sell a put instead. It obliges you to buy it at $150 but you receive a cash premium that you keep regardless of what happens afterwards. This way you basically get paid for having a buy order.

We saw some $150 put prices in Strategy 1. You can sell a December contract $0.39 or the April one at $3.43. If the price never dips, you keep the premium. If it does fall you have to buy the stock at the price you like and also keep the premium. A win-win situation.

Important notice on this strategy is to always have enough cash on the account to buy the stock if needed. Just as you would with a pending buy order.