When Investing In Options Is Smart, Safe

Few student investors spend a lot of time on options. I wanted to take a moment to write about a time when investing options is not only relatively safe, but also quite smart. We have to make a pretty big assumption that you have the purchasing power to own 100 shares of a stock. I figure since there are optionable stocks around $10, this isn't all that implausible.

Let's say that you are happy with your $1,000 position in Taser International (NASDAQ: TASR), but are concerned about its short-term prospects as well as that of the larger market through the end of the year. You don't really want to liquidate your position, but you also are not that sure that you will get much return in the next three months. That is to say that while you are still bullish on the stock, you believe the market range in the short term to be limited. This is where writing a covered call for the 100 shares can bring you instant income to make up for an assumed stable share price.

You think that it will bounce around $15-$19, but generally stay below $20. In this case, you write a covered call for January 2008 at the $20 strike price. This nets you around $145 in cash. When you write a covered call option you are selling someone the right (option) to purchase your stock at the strike price ($20).

So what could happen? Well, if the January options expiration comes and goes without the option being exercised, nothing happens - you just added 14.5% return to your portfolio. Let's say January comes and the contract is executed because the current price of the stock is $21. Well, at that point, your shares will be called away ended your position in TASER. This means you basically sold the position for $21.45 ($20 in selling it to the contract holder and $1.45 for the options premium). This isn't so bad, because you still stand better than you would be if you had just held the stock (you had the $145 to invest 3 months ago and your net was over 2% more than the current share price, plus any dividends if the stock pays any). If we reached the contract point and the price of TASER is, say $30.00, you would have lost $855.00 in potential gains.