How Are Stock Options Used?

by Tax Guy - Burlington Accountant on September 22, 2009 Print This Post Print This Post

Yesterday’s article answered the question: What are stock options? Today’s article builds on the topic of options and looks at some examples of how stock options are used in a portfolio.

Understanding Call Options

Call Option Seller or Writer – The seller of a call option has an obligation to deliver shares when the option is exercised. There are two different purposes for writing a call option. Each depends on whether you own the underlying shares or not.

  • Covered Call – You own the shares and have written a call option. If the option is exercised, you have locked in a gain or loss and must sell your shares to the holder.
  • Naked Call – You have written a call option buy do not own the shares. If the option is exercised you will have to purchase the shares on a stock exchange. This type of option carries significant risk as the price of the shares could increase significantly.

For example, assume the price of Bank of Nova Scotia is trading at $35.00 per share and you write a call and agree to deliver 100 shares of Bank of Nova Scotia at $50.00 per share.

If the share price exceeds $50.00 and your option is exercised you are required to deliver the shares. If you own the shares (covered), you deliver the shares at a price of $50.00.

If you do not own the shares, you will be required to purchase them on the stock market and the price may have risen well above $50.00 per share.

Call Option Buyer is acquiring a right to buy shares for a specific price. If the exercise price is less than the market price, you can lock in an immediate gain.

For example, you may hold an option to buy 100 shares of Apple for $125 per share. If the market value of Apple increases to say $150 you can exercise your option and buy at $125.

Understanding Put Options

Buying Or Holding Put Options – The buyer or holder of a put option has the right to sell a security at a stated price before the option expires.

If the price of a stock falls below the stated price on the option contract, the holder can buy the security on the stock market and then exercise the option and realize a profit. The risk of loss is limited to the price paid for the option and profit increases as the price of the share falls.

Selling or Writing Put Options – The seller or writer of a put option has an obligation to buy the underlying shares before the option expires.

In this case, the writer feels the price of a share will increase and seeks to earn a premium until the option expires. If the price of the stock actually falls below the stated price, then the writer is required to buy the shares for more than it is trading for.

Next In This Series

The next article in this series will show how call and put stock options are taxed.

About The Tax Guy...

Dean Paley CGA CFP is a Burlington accountant and financial planner who services individuals and business owners locally, nationally and internationally. Dean has appeared in the National Post, Toronto Star and Metro News.

To find out more, visit Dean's website Dean Paley CGA CFP or connect via Twitter @DeanPaleyCGACFP.

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