In this post we will discuss how to milk the stock market using options.
1. Contract: An option is a contract and legally binding.
2. Right to buy or sell: The buyer of the option has the right to buy or sell stocks.
- Call option: Right to buy stocks
- Put option: Right to sell stocks
3. Expiration time: The option has an expiration time. If you buy an option that expires in 30 days, you have the right to buy or sell the stock for those 30 days.
4. Agreed price: The price at which the buyer has the right to buy or sell the stocks is fixed. This is called the strike price.
5. Contract of 100: Each contract gives the buyer of the option to buy or sell 100 shares of the stock
6. Expiration date: Usually the 3rd Friday of the month
7. Premium: The money paid to purchase the option, a small percentage of the stock’s price.
Using put options to milk the stock market
Let us say you have a strong stock like Coca-Cola. The price of the stock is $40. I think the stock is overvalued at $ 40. I am only willing to pay $36 for the stock.
Some investors have bought Coca-Cola stock at $40. But they want to insure themselves against a major drop in the price. They want the ability to sell the stock at $36 if it does go down in price. To do that they have to buy a put option( right to sell the stocks). They have to pay a premium for doing so. Since I am willing to buy Coca-Cola at $ 36, I can sell the put options and collect the premium.
- If the price of Coca-Cola does not fall to $36, the premiums are mine. I make money.
- If the price of Coca-Cola falls to$ 36 or below, and the buyer of the put options decides to sell the stock, I have to buy Coca-Cola at $36. I am happy to do that, because I think that is a fair price to buy Coca-Cola.
Using call options to milk the stock market
Once, I buy Coca-Cola at 36, I have shares of Coca-Cola stock. Some investors would want the right to buy Coca-Cola stock at $40( either because they think Coca-Cola is going to $44 or because they are shorting Coca-Cola and want to insure themselves against a rise in Coca-Cola’s price). This means they have to buy a call option. Since I already hold the stocks at $36, I will sell the call options and collect the premium.
- If the price of Coca-Cola does not rise to $40, the premiums are mine. I make money.
- If the price of Coca-Cola rises to $40 or above, and the buyer of the call options decides to buy the stock, I sell Coca-Cola to him at$40. Once I do that, I go back to selling put options.
- You can also decide to sell a call option for $ 50 and make profit on the transaction.
- You should never sell call options if you do not own the stock. This is because you could lose a lot. For example, if Coca-Cola goes up to $50 and I do not have the stock, then I have to buy the stock at $50 and sell at $ 40, an instant 25% loss.
Understanding premiums for options:
- For Call Option:( right to buy a stock at a pre-agreed strike price): higher the strike price, lower the premium
- For Put Option:( right to sell a stock at a pre-agreed strike price): higher the strike price, higher the premium
The basic principle is that you should use only strong stocks to milk the stock market using options. Strong stocks mean stocks of blue-chip companies which have good ROIC/ROE and rising EPS with no huge debts or huge fixed costs and no falling product price. If you use options in such a way, it is reasonably safe.