Investors holding stocks or buying and selling stocks are familiar with “market” and “limit” orders. In placing a market order, they either buy or sell the target stock at the current market price when the order hits the trading floor. In placing a limit order, they are offering to sell or buy a stock at a specified price or “better”, better meaning lower than the specified price if they are buying or higher if they are selling.
Particularly for those who are frequently placing limit orders to buy or sell stocks, there is another approach that can accomplish the purchase or sale, but the investor receives or pays a better net price. This is accomplished through the sale of a call option to sell stock or the sale of a put option to buy a stock. Here is how each strategy works. All options are traded as representing 100 shares of the underlying stock. So, 1 call or 1 put option represents 100 shares of the stock.
Using a call option to sell a stock that is owned:
Suppose the investor holds 200 shares of stock XYZ currently trading at $50/share. This investor could place a limit order to sell at $60 that is GTC, Good Till Canceled. That order will sit there until the stock reaches $60/share, and it automatically executes or it could be canceled at any time. The investor may be willing to wait months for the execution, but that is fine with them as their target selling price is $60.
Another approach is to sell 2 call options with a strike price of $60/share. In this example, the investor sells the call options with an expiration out 90 days for $1. This means that the holder of the stock will receive $1/share or $200 as the option premium. This is non-refundable money, no matter where the stock price goes. The three possible outcomes are:
1. The stock sits still or trades in a tight range. The holder of the stock who sold the option keeps the $200 premium and the option expires without forcing the sale. This is the same result as the limit order, as the stock does not sell, but the holder of the stock is now $200 richer.
2. The stock drops in price. The holder of the stock has intended to hold for the long term and expects these dips, so they are not necessarily alarmed and would not sell in this situation anyway. They sold the call as above and collected the $200 premium. The result is that the stock is down in price, something they would have experienced anyway, but they can keep the $200, offsetting their paper loss by $1/share (commissions excluded).
3. The stock rises to or above $60/share before option expiration. The option buyer will force the sale of the stock at $60/share, the same result as the limit order. The holder of the stock ends up selling, but at a price $1 higher than their limit order due to the premium they received (commissions excluded).
The investor holding stocks they would sell at specified prices can just let limit orders sit, but using call options they can be taking in premiums along the way until the stock does sell at their chosen price. Also, over time they can adjust their price upward with a slow rising stock, enjoying even higher returns.
Continue reading on the next page to learn more about using a put option to buy a stock at a specified price.