Using Priceline.com Stock to Illustrate the Mechanics of Option Writing
I have a diverse set of interests, and two of my passions include eating assorted bon bons, and buying stocks low (selling them high). The only thing better than that is to also get paid for doing those same activities. Until I get paid for competing on the national bon bon competitive eating circuit, I’ll stick to getting paid for selling (“writing”) options.
The Mechanics of Option Writing
There are many places to learn about the basics of options, but for simplicity purposes think of options as tools for speculating, hedging, and generating income. Unfortunately, most people trading options lose money because of speculation and numerous shortcomings. Like guns, knives, or any other weapon, if properly used, these self-defense option tools can provide owners with significant benefits. If however the weapons are used irresponsibly, the consequences can be deadly. The same principles apply to options investing – beneficial in the right hands, disastrous in the wrong hands.
A Pricey Option Illustration
In order to illustrate the mechanics of option writing, let’s use Priceline.com Inc. (NASDAQ:PCLN) as an example:
Suppose I did my in-depth fundamental research on Priceline (NASDAQ:PCLN) and upon completion of my due diligence I realized that the stock is fairly valued at its current share price of $529. However, upon further consideration I realize I would love to buy 100 shares at a discount price of $500 if Priceline shares pulled back. In mirror-like fashion my fundamental valuation process may also indicate an adequate selling valuation level at a $560 premium.
Based on these previous assumptions, I could profitably sell (“write”) one naked put option with a strike price of $500 and an expiration date in October (approximately five months from today), in exchange for $3,560 in upfront cash less comissions.* That’s right, someone is going to pay me thousands of dollars to buy something I am openly willing to purchase at lower prices anyway. In bon bon terminology, speculators are paying me to eat bon bons, an activity I love even without upfront cash payments from others. In the case of an escalating Priceline share price, I prefer to sell covered calls (i.e. own underlying stock position plus simultaneously selling a call option), consistent with my valuation sell price targets (strik price of $560 per share).
Since writing options is effectively like selling insurance, it intuitively follows the best time to sell insurance is when people (investors) are the most nervous. If you were a fire insurance carrier and wanted to maximize collections, setting prices a week after a large fire in the hot, dry summer season around the firework-laden 4th of July may not be a bad choice. In the equity markets, the VIX (Volatility Index) is often referred to as the “fear gauge,” which can be used as an indicator to optimize premium collections from options sales.
Options, which are part of the derivatives family, get lumped into these wide set of financial instruments that billionaire investor Warren Buffett called “weapons of mass destruction.” The ironic part of that whole situation is that despite the evil titling of these instruments, Buffett has used these “weapons of mass destruction” extensively, more recently with his strategies related to selling index options. For those who followed the financial crisis of 2008-2009, observers fully realize that American International Group (NYSE:AIG) was selling insurance on credit defaults (Credit Default Swaps). Regrettably, the CDS market was not regulated to a similar extent as the more sophisticated options and futures market.
Eating bon bons for pay can be satisfying, and so can trading stocks for cash, when buying them low and selling them high. On the other hand, these same activities can prove to be harmful if abused or misused. If you eat bon bons in moderation, and receive premiums from thoroughly researched naked puts and covered calls, then you have nothing to worry about.
Wade W. Slome is a CFA and CFP® at Sidoxia Capital Management.
Disclosure: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct positions in securities referenced in this article.
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