Call Options Explained - Using Call Options to Generate Cash Flow

hi I'm Jimmy, this video is the start of a new series on stock options so in this video we're gonna look at a few different ways we can use options one of them to generate cash flow for our investment portfolio a lot like dividends then in future videos within this series I'm going to touch on a bunch of different options strategies that gradually get more interesting and more dynamic so hopefully we can use options to generate income for our portfolio or maybe protect our portfolio on the downside the amount of ways we can use options the list goes on and on okay so let's kick it off so we have two investors our first investors name is Jimmy he wears a t-shirt that says hi I'm Jimmy because for some reason he feels the need to introduce himself every time we see him clearly he's got issues he's working through and our second investor well clearly she's quite confident just look at the way she's standing her name is Emily and she does not feel the need to say hi I'm Emily every time we see her okay enough about them so as one piece of her portfolio Emily Owens shares a Verizon in fact she owns 100 shares of Verizon and this is important because generally speaking one option represents 100 shares of stock she bought her 100 shares back in June where she paid an average price of $57 and 3 cents now a few months have passed and she's up a bit in the stock since the current stock price is about $60 per share now she's been able to collect some dividends over that time as well so her total return is a bit better than it looks at first glance but now she's looking to generate more cash flow so she could put that money to work in some other potential positions she's been considering she's considered selling her verizon shares but doesn't mind holding it for now now Jimmy on the island well he really likes Verizon stock but he doesn't have all the money he needs to buy the 100 shares that he wants to buy and he thinks that Verizon stock is going to go up or he's afraid it's going to go up over the coming months before he gets together enough money to buy the shares he wants so clearly what do they do to get involved in options so Emily decides that she's going to sell one call option and Jimmy decides that he's going to buy one call option now just so we're all on the same page these two investors never actually meet they never actually find out about each other each of them place their trades with their own brokerage firm and then everything gets done from there behind the scenes so you'll never actually know who's on the other side of the trade I'm just running these two stories side by side so we could see the way they're both thinking okay so Emily's selling the call option and Jimmy's buying the call option so what is Jimmy buying and how much does he pay well Jimmy is buying the option to buy Emily's 100 shares of Verizon stock so Jimmy goes ahead and he pulls down an options chain which is basically a bunch of quotes for options this is what that looks like now I pulled this down on January 8th and we could see that this group of options expire on March 20th that's 72 days away from the day I pulled down the quote so this tells us that if he buys one of these options by the way each one of these lines represent a different option well if he buys one of them he must decide what he's going to do with the shares or with the option no later than on the close of business on March 20th because that's when these particular options expire okay simple enough so whatever Jimmy is going to do he has to do it by the 20th by the expiration date so we know that he's going to have the option to buy Verizon stock by that date but what price is he going to pay for it well that's what the strike price is he gets to choose any one of those strike prices whichever one he wants to buy and he then has the option to buy 100 shares at that strike price now you might ask how do we know that this is for a hundred shares and almost all options trade in blocks of a hundred shares they almost always represent a hundred shares so they're not going to indicate it anywhere there we just have to know one option represents 100 shares of stock so if he wants the option to buy 100 shares of Verizon stock at $60 per share well he would have to pay $1 42 per share today that would give him the option to buy those shares at $60 if he's willing to pay $62.50 well he would have to pay just $49 which is the same as 49 cents per share because it's important to note that we should notice that these quotes are generally in a per share basis even though they are talking about one options contract we know that an option represents 100 shares so 49 cents turns into 49 dollars as the total cost for the option but there's one issue Jimmy isn't sure if he's going to have the sixty two hundred and fifty dollars needed to buy all 100 shares by March 20th so he says all right what if I switch to a longer-term option so he switches over to April 17th which is a hundred days away now if we're wondering where these dates come from for the different options well it's actually the third Friday of any month is when monthly options expire there's some shorter term ones but broadly speaking monthly options expire on the third Friday of the month now we may notice that the price of these options went up the strike price remains the same don't forget the strike price is how much we would buy how much we would pay for the underlying stock but the option price went from costing Jimmy $49 last month to $60 in this month and that makes sense if we think about it because Jimmy bought another month that extra $11 is called the time value you're going to the more time you want the more it's gonna cost you so let's imagine that this is the option he decides to go with he pays 60 bucks and right now he owns the option to buy 100 shares of Verizon stock at 62 dollars and 50 cents and he knows he has to do it on or before April 17th of 2020 okay so he places the order with his brokerage firm luckily he doesn't pay any Commission's well they automatically deduct the $60 that the option is costing him right out of his brokerage account right now okay Jimmy's done now let's flip the story back to Emily who's still trying to decide what she's going to do so Emily is also coincidentally focusing on the April 27th options as well and don't forget she already owns the 100 shares of Verizon stock so what is Emily thinking well Verizon stock currently pays a dividend quarterly dividend of about 62 cents per quarter this is decent but Emily's looking to generate more cash flow out of this position so what she's going to do is she's going to sell somebody else in this case Jimmy she's gonna sell somebody the option to buy her shares and they will essentially pay her to do that now conveniently for our story she chooses the same option that Jimmy chose expiration date of April 17th strike price of sixty two dollars and fifty cents so she knows that if somebody exercises this option on her they elect to take the shares from her they have to pay her sixty two dollars and fifty cents per share she doesn't mind that because she bought the stock down near 57 so she's willing to sell it for a profit so she goes online to her broker she places the sell one call option order and she gets the same price as Jimmy pretend she got a sixty price of sixty cents per share or $60 generally if we're going to sell an option that's the column you're that's usually the price you would get but for the case of a story let's pretend she got sixty bucks as well okay so now what happens to Emily well much like what happened to Jimmy the $60 trade that she just placed in this case gets deposited directly into her account so she gets that $60 right away much like a dividend payment well now the option is out there and what they end up doing is I both end up sitting and waiting I don't forget she does not have the option here the option goes to the buyer of the option she sold the option she's not in control as to whether or not they exercised this option on her and luckily she already owns the 100 shares of Verizon stock needed to fill the option if it ever is exercised if she only owned 99 shares or 50 shares of 0 shares well it would be considered an uncovered call option or a naked call option those are bit trickier we'll get into those in another video so for now she owns 100 chips now let's fast-forward to expiration day to see what Emily and Jimmy are doing well there's two scenarios scenario one Jimmy was wrong Verizon stock doesn't move higher like he thought it would it moves a little bit higher but not much instead it moves to 61 dollars per share and this is on the day of expiration scenario 2 while Jimmy was somewhat right and Verizon stock is trading at $65 per share now we can't forget that both of these people that got involved in this option well the option of the stock at the time Verizon stock was trading at about $60 per share so scenario 1 is the easiest the option says that Jimmy can by the shares of Verizon stock if he wants to for $62.50 that was a strike price but with the stock currently trading at $61 well there's no shot Jim is going to pay 60 250 when he could just buy the 100 shares on the open market for sixty one dollars so what happens well at the end of that trading day at the end of expiration day the option expires worthless and Jimi's out the $60 that he paid for that option the fact that the stock went from $60 per share which is where it was trading up to sixty one dollars or sixty two dollars is irrelevant it didn't get above the 60 to 50 so the option expires worthless now scenario one works out quite well for Emily because don't forget she bought her shares of Verizon stock back in June where she paid about $57 and three cents now the stock is trading about sixty one dollars so she's up about four dollars per share or four hundred total dollars plus she already got the $60 premium that she received when she sold the call option so she's up four hundred and sixty dollars and this does this serves the exact purpose she was hoping for she got to generate some extra income with this put with this position on top of the dividends she would have collected in the meantime now the beautiful part to this for her is that perhaps she can do this again the stock is now at sixty one dollars per share maybe she goes out sells an other options for three months away from the current price again but instead of doing 60 to 50 maybe she decides to do a $65 option this could in theory help her generate a decent amount of income until the stock gets called away from her okay how about scenario two well in scenario two Jimmy gets to decide what he wants to do at this point the stock Verizon stock is trading about $65 per share and their Trump the options at that time would most likely be trading for about two dollars and 50 cents per share since the current stock price 65 is two dollars and fifty cents above where Jimmy's allowed to buy it which is 60 to 50 so we can assume that would be trading right around that point now that means that if Jimmy wants to buy the shares he needs the $6,250 to come those shares which covers the entry price of those he already paid the original $60 from the option premium early on he doesn't have to do that now right now it's just a matter of putting up the cash to buy the actual shit's now let's pretend he doesn't have the money pretend he couldn't come up with the money to buy the shares well another choice for him is to simply sell the option he owns it he bought it he that's listed in his account right now he could just place an order to sell that like we said it's probably worth about $250 so he paid $60 to get into the option he sold it for $250 not bad over the 3 month time period not a bad profit so maybe that's what he decides to do now an Emily's side we might be asking what is she doing in this Ulsan air well in scenario 2 with the stock being in the money they call it in the money when the current price is above the strike price with the stock being in the money she's going to lose her shares that's going to happen now we might be asking well maybe what if Jimmy decides to sell the call option and he doesn't actually exercise the option either way it's going to get her shares are going to be gone even if that happened the brokerage firm would jump in and take the shares and they could buy their shares from her for 60 to 50 and sell them right away for $65 so we just have to assume her shares are gone no matter what unless of course she chooses a different option and her other choice besides letting her options get exercised another choice for her would be to simply buy back the option that she originally sold Josie so she sold it to start their trade now maybe she buys it back what would happen there well again we're assuming that option is worth $250 she would have to buy it for $250 and it's going to expire at the end of the day so essentially she sold something for $60 bought it for 250 she would take $190 loss but if she wants to keep her shares that might be worth it to her since the stock is up more than two dollars and 50 cents per share or two hundred and fifty dollars from where she had the exercise price so if she had decided at any pointed that she wanted to keep the shares well she could simply do the reverse of the original trade she originally sold now she would buy it back to close up so those are the two primary choices on both sides of the trade do you sell the option or do you buy the option do you get out of your current position is probably a better way to put it or do you exercise the option now we have to remember that Jimmy has the option to exercise he could have exercised today on expiration day could have done on a week ago a month ago so as the seller of the option emily has to be aware that those shares to get taken away from her at any time well she does know is that it has to happen before the expiration date and she knows what price she's going to get maybe she doesn't mind that she bought the stock at $57 and now it's that if she if it got exercised she'd get 62-54 not too bad plus whatever she gets when she sells the option so as we can imagine call options can be used in many different ways now the other side of the option coin is the put option which gives the buyer of the put option the right to sell shares of the stock at a certain price by a certain date well dive into that topic next but if you're interested in learning more about put options right now well this could be a good next primer video for you to watch there's a link and there's a link in the description below and thank you so much for stick with me all the way into the video I really appreciate it I know this was a longer video thanks and I'll see in the next video

Channel: Learn to Invest

Views: 136,961

Rating: 4.9224677 out of 5

Keywords: Investment Ideas, learn to invest, investing for beginners, stock market, call options explained, call options trading for beginners, call options robinhood, call option, covered calls, covered call for income, covered calls explained, how to use covered calls, when to buy a call option, buy call option, sell call option, write call option, options explained, call option example

Id: RsxmuQlNCKQ

Length: 14min 38sec (878 seconds)

Published: Fri Jan 10 2020