What are Options?

An option is simply a financial contract.  Every option has a buyer and a seller. There are two types of options, calls and puts.  The buyer of a call option has the right to buy a particular security at a specific price for a defined amount of time.  The buyer of a put option has the right to sell a particular security at a specific price for a defined amount of time.  The seller of a call option is obligated to deliver the security at the specified price if the buyer chooses to exercise, while the seller of a put option is obligated to buy the security at the specified price if the buyer chooses to exercise.

A Call Option Example

This sounds complicated, but it really is quite simple.  The easiest way to understand a call option is to consider a real estate example.  Suppose I own a piece of property worth $100,000.  Speculators are willing to pay me for an option to buy my property.  So let’s say I agree to the following terms:  I will sell my property for $105,000 at any time during the next 6 months.  For this obligation the speculator must pay me a premium of $5000.  I have just sold a call option on my property.  Let’s explore the potential outcomes after the six month time period passes.  First, the option can expire and the speculator may choose not to exercise.  This is guaranteed to happen if the property value remains below the agreed upon purchase price.  Think about it, why would someone buy the property for more than it is worth in the free market.  In this case, I keep the $5000 premium, which is a cool 5% return in 6 months.  I also keep the property, since the option expired worthless.  Now I am free to sell another 6 month option with new terms.  Not bad, since all I had to do was agree to sell the property at a certain price that was MORE than its current value.  The second outcome is that the property value rises and the speculator exercises his right to purchase the property.  In this case, I am obligated to sell the property for $105,000.  If the property value appreciated significantly, the speculator makes a large profit.  The speculator is paying for leverage, being able to control a large asset with a small amount of money.  How did I come out in this case?  I still keep the $5000 premium, plus I gained $5000 on the sale of property, compared to its value when the option was sold.  So I made a very respectable profit on the transaction.  What I gave up was the potential for a large upside.

This is the essence of covered call writing.  Just as the property owner in the real estate example, we sell call options against our diversified ETF portfolios to generate income.  We give up the potential for large upside in return for consistent monthly income.  In our model portfolios we sell options every month.  Our strategy performs best when the market is drifting sideways.  When the market moves up aggressively, we may underperform in a given month.  But over time, in months when the market is flat to slightly negative, our call premium provides very consistent income and greatly enhances long term returns.