You don't need to be a professional trader to use options. Image source: Getty Images.
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Whether you're a bull, bear, or you have a neutral outlook on the stock market, there are ways to put the power of options to work for you. And, you don't need to be an investment genius to do it. Here are two basic strategies that you can use to generate income, protect your capital, and profit from volatility.
Covered calls can generate income and limit your losses
Selling covered calls is perhaps the most basic options strategy there is. Essentially, you are selling someone else the right to buy stock from you for a certain price at any time before a specified date.
The best way to describe this is through an example. Let's say that I own 100 shares of ExxonMobil, which is trading for about $85 as I write this, and I don't foresee any massive price swings in the near future. I could sell one call option (remember, each option contract is for 100 shares) expiring on the third Friday in January 2017 with a strike price of $90. In return, I get a premium of $140, which I get to keep.
There are a few different ways that this trade could play out:
1. ExxonMobil could drop, and be below $85 per share in January. This would be unfortunate, but remember that you received a premium of $140 ($1.40 per share) for selling the option. You get to keep that income which helps to lessen your loss, the option expires worthless, and you get to repeat the process.
2. ExxonMobil could rise slightly, but stay below $90 through January. This would be the best-case scenario. Not only would you be sitting on a nice gain with the stock, but you get the premium from selling the option added to your gains. And, you are free to sell another option on your stock.
3. ExxonMobil could have an excellent fourth quarter and be above $90 at expiration. In this case, your shares would be "called away," meaning you'd be forced to sell them for $90 apiece, no matter how high they climbed. This would produce a nice gain -- a $5 rise in price plus a $1.40 options premium translates to a 7.5% return in just four months. The risk, however, is missing out on gains if the stock price goes through the roof. Even if the stock rose to say, $125, you'd be forced to sell for $90.
4. The stock price doesn't move at all -- it expires at the same price as it was when you sold the covered call. From an income standpoint, this is a good outcome. The option you sold expires worthless, and since you still own the stock, you're free to repeat the process.
In a nutshell, a covered call allows you to generate some income and provides some degree of downside protection, in exchange for giving up some of your potential for share price gains.
In-the-money calls as a stock replacement
Option prices have two components -- intrinsic value and time value. Intrinsic value is the amount of money that an options contract would be worth if it expired right now. For example, a contract with a $10 strike price to buy a stock trading for $15 would have an intrinsic value of $5. Time value is the premium you pay for what could happen before expiration. If that options contract was trading for $6, $5 would be intrinsic value and the other $1 would be time value.
As your options get deeper in the money, the time value fades away and intrinsic value makes up most of the option price. Therefore, you don't have to pay a time premium to buy a deep-in-the-money option, and it can be used in place of owning a stock.
Let's say that I want to buy shares of Amazon.com, but I don't want to lay out the $77,000 it would cost to buy 100 shares. Instead, I could buy a call option expiring in January 2018 with a strike price of $400 for a premium of $380. Only about $10 (2.6%) of this is made up of time value, and you'll benefit from price increases of 100 shares of Amazon.com stock for $38,000, about half the price of buying the shares outright. In a way, this is like buying shares on margin, but you don't have to pay margin interest, which is generally far more than the time value you'll pay.
The risk in doing this is if Amazon were to fall below $400 before 2018, you could lose your entire investment. As unlikely as it is, it's certainly possible. Using options as stock replacement certainly has its perks, but at the cost of more risk.
Start off conservative
As a final thought, it is admittedly very easy to lose money in options if you don't know what you're doing. Therefore, it's important to start out slow. Maybe buy one deep-in-the-money call option on a stock you'd like to own, and then use it to observe the pricing dynamics of options and get a good feel for how a trade like this plays out over time. Or, maybe sell a far out-of-the-money covered call on one of your current holdings. It won't generate a ton of income, but the point is to learn.
The bottom line is that you can read about options until your eyes cross, but there's no substitute for real-world experience. So, if you do decide to add options to your investment toolkit, it's important to do so slowly.
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Matthew Frankel has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Amazon.com. The Motley Fool owns shares of ExxonMobil. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.