Investing with options - Adobe earnings
Summary: Adobe's recent dip before earnings release creates opportunities and risks for investors, and options strategies can help navigate the turbulent waters. In this article we take a look at those opportunities and how you could profit or control risk using various options techniques/strategies.
From zero to hero: selling options
Basics of selling options
What does it mean to sell options?
Why sell options?
- Income through premiums: Regularly selling options can create a consistent stream of income from the premiums collected.
- Potential ownership at a lower price: If there's a particular stock you have your eye on and would consider buying at a reduced price, selling put options might be a strategy to explore.
Types of options you can sell: call and put
- Selling a Call Option: When you sell a call option, you're essentially taking the opposite viewpoint of a call buyer, who is bullish on the stock. Let's take an imaginary company, BigCompany, as an example, which is currently trading at $50 per share. You believe that in the short term, the stock will not appreciate significantly, and therefore you decide to sell a call option with a strike price of $55 for a premium of $1.50 per share (or $150 in total, as one contract typically controls 100 shares).
In this case, your break-even point at expiration is $56.50, which is obtained by adding the premium received to the strike price ($55 + $1.50). You would retain the entire premium if the stock price remains below $55. However, if the stock price surges above $56.50, you'd start experiencing losses, since you would be obligated to sell the shares at $55, even though they are trading at a higher market price.
Below is a screenshot that visualizes this concept (it uses other prices, but the principles remain the same). In bullets 1, 2 and 3 the outcome of selling the call is profitable, only bullet 4, a steep rise contradictory to the assumption, is negative.
2. Selling a Put Option: Conversely, selling a put option means you're taking a stance contrary to a put buyer, who is bearish on the stock. Going back to our imaginary BigCompany scenario, if you speculate that the stock will not decrease much from its current $50 price point, you might choose to sell a put option with a strike price of $45, earning a premium of $1.50 per share or $150 in total.
How to profit and manage risk while selling options
Making money through premium collection
- Premiums as a Safety Net: When you sell options, the premiums you collect can serve as a safety net, adding some cushion to your financial endeavors. Here's how:
- Selling a Call Option: If you are selling a call option, you are agreeing to sell the underlying asset at a specified price within a set period. If you own the underlying asset and are willing to sell it at the strike price, the premium you collect can help cushion any potential decrease in the asset's market value. Essentially, it provides a buffer, securing you some earnings irrespective of the asset's market movements.
- Selling a Put Option: Conversely, when you sell a put option, you are agreeing to potentially buy the underlying asset at a predetermined price. If you intend to buy the asset at the strike price, the premium you collect can offset a potential rise in the market price, acting as a safety cushion that mitigates the higher purchase price.
2. Utilizing Time Decay: Options lose value over time, a phenomenon known as "time decay." As an options seller, time decay works in your favor. The closer the option gets to its expiration date without being in the money, the more its value decreases, potentially allowing you to buy it back at a lower price than what you sold it for, pocketing the difference.
Understanding and managing the risks
- Potential for Large Losses: Selling options can potentially lead to substantial losses, especially if the market moves sharply against your position. It is essential to be aware of the potential losses and to manage your risk appropriately.
- Margin Requirements: When you sell options, you are required to maintain a margin account. This means that you need to have a certain amount of capital in your account as a security. Being aware of the margin requirements is vital to manage your risk effectively.
- Early Assignment Risk: There is always a risk of early assignment when selling options. Early assignment happens when the buyer of the option chooses to exercise their right to buy or sell the underlying asset before expiration. This risk can be managed by keeping an eye on the intrinsic value of the option and being prepared to take action if necessary.
Strategies to mitigate risks
- Setting Stop Losses: One strategy is to set stop losses to limit potential losses. A stop loss is an order placed to buy or sell once the stock reaches a certain price.
- Spreading: Another strategy is to use spreads to limit potential losses. In a spread, you sell one option while simultaneously buying another, helping to cap both the potential profits and losses. Spreads is what is called a "options strategy", which we will cover in future "From zero to hero"-articles.
- Hedging: Though we are keeping it simple in this guide, know that there are advanced strategies like hedging that can further help in managing risks, which you might explore as you become more comfortable with options trading.
Crafting a strategy and identifying opportunities
Analyzing Market Conditions
- Volatility: Understanding the volatility of a stock can help in determining the potential premium you might receive from selling an option. Typically, higher volatility leads to higher premiums.
- Economic Indicators: Keeping an eye on economic indicators and news can provide insights into the potential movements of the stock market, helping you to make informed decisions.
- Company Performance: Before selling options on a company’s stock, consider the company’s performance, financial stability, and future prospects.
Developing a Strategy
- Covered Calls: If you own shares of a stock, you might consider selling call options on that stock to generate additional income. This strategy is known as writing covered calls.
- Cash-Secured Puts: Another strategy is selling put options while having the necessary cash to purchase the underlying stock if it gets assigned. This strategy, known as cash-secured puts, allows you to potentially buy the stock at a lower price while earning a premium.
- Naked Options: For the more adventurous investor, there's the strategy of selling naked options. This involves selling options without owning the underlying asset, a strategy that comes with higher risk but also higher potential rewards.
Tools and Resources
- Trading Platform: SaxoInvestor and SaxoTraderGo are excellent platforms to start your options-journey. SaxoTrader Pro is our top of the line platform for advanced trading and research.
- Educational Resources: Continuously educating yourself through reliable resources aids in making informed decisions. Plenty of high quality content can easily be found via search engines, Youtube and others.