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Monday, March 7, 2011

How to write a stock option

Writing a stock option is the same as selling a stock option i.e. an option to buy or sell stocks at a specific price on or before a specific expiration date. Since stock options can be used to both buy and sell stocks, writing a sell or put option is the same as selling a financial instrument that allows the buyer to sell that financial instrument a second time. Just as a wholesaler sells to a retailer who then sells to a buyer, a similar scenario holds true for writing put options.

Writing a stock option requires several pre-requisites including an account with a financial institution that facilitates the trading of options, a knowledge of how stock options work, and enough capital to meet financial requirements arising from any margin or exercising of the written option contract(s). Anyone can write options, there are no licenses or permits required. However, since stock options are leveraged financial instruments that derive their value from underlying stock prices, the writing of options can be risky.

After having opened and funded the appropriate brokerage account the next step in writing a stock option is deciding if it is the right financial decision. Generally, if you can afford to lose the capital necessary to implement the stock option, and have a tolerance for risk, then it is more possible stock options may be a good financial instrument to explore investing with. Following the decision to write option contract(s), a next step after that is to determine what your financial objective is. Since that objective is probably to make money, the goal could be to make $100.00 with relatively little downside risk.

In light of the above financial goal, Mrs. H decides to sell 10 call options, each of which represents 100 shares, at a strike price of $10.00. That means Mrs. H is writing a 10 stock options to sell to a buyer who hopes the price of a stock is going to rise.  In such case, Mrs. H will sell to open the options. If the stock price rises above $10.00, Mrs. H has a right to buy 1000 shares for $10.00 for the cost of the shares plus the option premium. If the option premium or cost is not lower than the difference of the number of shares multiplied by the difference of the new share price and the strike price, the options are not profitable.

To illustrate the above example further, Suppose Mrs. S wants to buy the 10 options written by Mrs. H. The cost of the option to buy shares written by Mrs. H is $2.00 per share or $2.00 x 1000=$2000.00. The strike price for the options is $10.00 and the actual stock price is $12.00. This means in order for Mrs. S to recover her stock option premium, the price of the stock has to rise above  $12.00 per share as she can then buy the options at $10.00 per share then resell them for a profit. Otherwise, the cost of the option is either only partially recovered i.e. out of the money or recovered without profit, i.e. at the money. If Mrs. S decides to exercise her options, Mrs. H must sell the shares to her at the strike price. Stock options are explained further in the instructional presentation that follows:


Although stock options are potentially lucrative investments, there is a considerable amount of risk associated with them. For example, since stock options are financial derivatives, they are leveraged meaning more money that is actually at hand may be utilized in the contract. If the stock option loses value, the brokerage firm through which the contract is facilitated may issue a margin call or a request for money to cover the difference in losses. Before choosing to invest using this type of financial instrument, be sure to carefully undertand the details and risks.

Sources:

1. http://bit.ly/ajU7Hx (Nasdaq)
2. http://bit.ly/dAH1S5 (Scottrade)
3. http://bit.ly/ab1cxp (Options Industry Council)