Full Disclosure Finance

By Andrew,

Jeff McLarty from the financial blog Blue Moat was nice enough to write a post on his site answering some of my options related questions that have come about regarding some of the recent posts on this site. Anyone interested in understanding the nitty gritty of options trading should check it out. He explains in depth the terminology and fundamentals behind both sides of an options trade (puts and calls), as well as the possible scenarios at expiration. Also, if you’ve never visited his site before you should give it a read. Its one of this sites that I visit regularly. He’s a fellow Waterloo alum, so you know that he’s good people.

One specific question that I had was related to the covered calls strategy that I wrote about recently. My understanding was that the only way to exit the contract was to let the options expire (ideally worthless so you keep your shares and the premium). However, Jeff left a comment on the post saying that another way to exit the trade is to buy the calls back. As the calls near expiration the options become less valuable and, as a result, the premium will decrease in value (this illustrate the time value of options). Therefore, your profit will be the difference between the premium you collected and the premium you pay to buy back the calls. Typically he buys the calls back when they are very close to worthless. Why risk losing the potential upside in the stock for an extra $0.05 per share. He almost always sells the front one or two months, usually one or two strikes out of the money. Of course there is the risk of losing your shares with this strategy but the idea is to sell the calls at local peaks where, if the stock does hit the strike you wouldn’t mind taking the profit and selling your shares anyway. Plus you are pulling in the premium every month that options expire worthless. The ideal stock for this strategy would be a slow moving stallwart that trades in a well defined range so you can easily identify the sell points (the local peaks).

Thanks again to Jeff from Blue Moat for sharing his expertise with us and answering some of my questions.