Options and Realized Gain: The Basics

There are only two option instruments: calls and puts.   That’s it, only two instruments.  These are the building blocks of every option strategy.  There are lots of strategies that use options, some simple and some very complex.  I’ll stick to one simple strategy: selling cash secured (covered) options.   A strategy doesn’t have to be complicated to be effective.  For an example in the geo-political sphere, Reagan’s strategy to beat communism was simplicity itself: we win, they lose.  It worked.  Its simplicity provided focus and clarity.  In many situations, less is more. 

I’ll get to trading and modeling shortly but first, the basics of the instruments.  A call option buyer pays a premium to obtain the right to buy a particular stock at a particular price within a particular time frame. The particular stock is called ‘the underlying’, the particular price is ‘the strike price’, and the particular time frame is the ‘time to expiration’. The call seller (that’s you and me) receives the premium and any dividends, but gives up the right to continue owning said stock should the call buyer exercise his option. Note that a call buyer has purchased a right; he has no obligation to call the stock and will only do so when it is economically advantageous.    So when will the call buyer exercise this right?  You guessed it: when it is economically attractive to the buyer and therefore unattractive to the seller – that is, when the price of the stock in question is above the strike price.   

A put works inversely to a call: a put option buyer pays a premium to obtain the right to ‘put’ (i.e., foist upon you and me) a particular stock at a particular price within a particular time frame.   A put buyer also will exercise the option when he finds it is economically advantageous – when the price of the stock in question is sufficiently below the strike price with sufficiently little time value remaining – thus receiving the higher strike price for something that is now worth less (not worthless …. worth less) than the strike price.   A put seller does not receive any dividends, since he doesn’t own the stock on which the put is written.   

It’s helpful to look at this game from two perspectives.  In one view, think of the call buyer and the put buyer as your opponents in a zero sum game.  They’re speculating on the market.  A call buyer thinks the price of the stock will go up; a put buyer hopes it will go down.  You are selling them something, at a price, to allow that speculation.  But you’re speculating too; you’re taking the opposing view.  You hope to gain from that transaction, but so do they.   Only one of you will win.  It behooves you to clearly understand the circumstances under which you’re likely to win, and to time and structure your trades accordingly to maximize your profit.   

That’s one view, and it’s not wrong.  But there’s another view to consider that may be helpful.   In this view, you’re an insurance salesman.   Let’s say someone owns a stock, and they’re worried about the price falling.  One way to hedge that risk is to buy a put – to offset price declines in the stock.  That someone pays a premium (the price of the put) to you, the put seller, to obtain this protection.  The analogous situation for calls occurs when someone who has shorted a stock wants to hedge his position.  Buying a call is one way to do that.  You sell them this insurance protection for a price, just as you did the put.  Think of yourself as doing a public service, rather than being a rapacious speculator.  Similarly to any insurance provider, you want to understand whether the premium you’re receiving will cover your expected losses – not necessarily on each and every trade, but in the aggregate across a number of trades.   More specifically, you want to understand how to optimally time and structure your trades (your insurance sales) to maximize your profit.  More to come on this in a bit.  But first, let’s be clear on what I mean by profit.   

For purposes of this website and model, profit (aka income) is realized gains plus any dividends.   You’ll own some stock, because we’ll be doing covered calls; therefore you’ll get some dividends.   I monitor unrealized gains / total return in my actual trading, but it’s not my driver.  My focus is generating realized gains and dividends – aka, new money.   I’ve found that if I focus on this, total return takes care of itself.   It’s important to understand how the accounting for options works, when and how realized gains occur, if you’re to understand how the game is to be played to maximize your profit.   It may seem a bit tedious, but bear with me.  Understanding how gains flowed through Fidelity’s accounting system was a huge step forward in my trading.  I’ll start with puts, which are a little simpler than calls.   

When you sell a put, several things happen a nano second after the trade: entries are made by Fidelity (my broker) to three accounts, and cash is secured that is no longer available for you to trade.  Here’s the fact set for a simple example: 1 put contract, struck at $10/share (i.e., the strike price), with a cost of $1/share.  ‘Cost’ is from the perspective of the buyer of the option; for the seller, it’s premium.  Assume the underlying stock price is also at $10/share, so the option is struck at-the-money.  Also assume the term-to-expiration of the option is 2 months.  You can readily calculate that 1 contract (which by market convention is for 100 shares of stock), will require the securing of $1000 cash (1 contract x 100 shares/contract x $10/share strike price).  Further, you can readily calculate that $100 premium is received (1 contract x 100 shares/contract x $1/share).  On a base of $1000 at risk, over a term of 2 months, this premium provides a prospective period return of 10% ($100 / $1000), and a prospective annualized return of 60% (10% / 2 month TTE x 12 months/year).  This is just an example, and prospective returns at that level are rarely seen (though 30% and 40% prospective annualized returns are not uncommon).  Here’s how the accounting looks a nano second after you pull the trigger on the trade:

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Book value is the same as purchase cost; the terms are used interchangeably.  Once a trade is booked, the book value remains constant (there are exceptions to this in the bond world, but not here).  You’ll notice the BV and MV entries are negative, since you sold the option.  There is an equivalent and offsetting increase to the cash account.  You actually did get $100 (options settle in two days, but the accounting entry to cash is immediate).   That’s the insurance premium paid to you.  If you were to add up the book values including cash, and the market values including cash, of all your positions, you would find that a moment (nano second) after the trade, there’s no change.  The cash received is offset by the negative BV and MV entries for the short option.   But then what happens, say a few more nano seconds later?    The market value will begin to change.   It’ll go up or down, depending on Mr. Market.    Since you are short the option, you want the price to go down (the negative value to decrease).

Now, by the time the option expires, one of three things will happen.  That’s it; it’s a very finite set of possible outcomes.  Either the option is bought back, preferably when the price has gone down, thus closing out the trade.  Or the option expires worthless (out-of-the-money).  Or the option expires in-the-money and the stock is put to you. Expiring out-of-the-money is like selling insurance and the house doesn’t burn down and the car doesn’t crash.  This is the outcome an insurance company and you as an insurance seller hope for.  When you’re an option seller, an option expiring in-the-money is like having the house burn down or the car crash.   To further this example, let’s run some numbers for these three scenarios. 

First, the buy back.  Assume the price of the underlying has increased, and therefore the short option has decreased to, say, -$0.5/share – half the negative value it had at the beginning.  This is great.   You sold something when it was expensive, now you can buy it back when it’s cheap.   Buy it back.   This buy back reduces your cash account by $50.   Buying back a sold option has the effect of eliminating it.  Since the option is now gone, it has no remaining book value or market value.    You have a $50 realized gain, and $50 more cash than you had at the start.   This means your total portfolio book value and market value have gone up by $50.  This means you have $50 new money available to trade and to generate (compound) further return.   While you didn’t make (get to keep) your entire premium of $100, you get to play the game again (do an inventory turn sooner than the term-to-expiration) and you did not have the put exercised (in-the-money).  You can do this all day long.  Here’s how the accounts look:

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Now, let’s consider when the underlying increases, but the option does not cheapen enough to warrant buy back, and therefore it expires worthless.

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Once again, the option is gone.  That’s what expiration means.   Since you didn’t buy it back, there’s no cash outflow.  You keep the entire premium that you received, and your realized gain is, accordingly, the full $100.  But, in contrast to the buy back situation, you had to wait until expiration to get your money freed up.   So, here’s a simple thought experiment.   For this example, with a 2 month term to expiration, all things equal, if you can buy it back in, say, under a month, and keep, say, half the premium or more, and get to play again at the same prospective return rate, you’re ahead of the game.   This turns out to be extremely important: most options I sell do not go to expiration. Now let’s consider the situation where the option expires in-the-money (the house burns, the car crashes, and the insurance policy is activated).   You’ll recall that this was a juicy deal, with a 60% prospective annualized return.  The operative word is ‘prospective’.   It’s juicy until it’s not; that is, until the stock is put to you.  Then the secured cash is used to pay for it, and you take possession of the stock at the then market price.  We’ll assume in this case, $5/share.   Since you have 100 shares for the 1 option contract, the value of the stock foisted upon you is $500.  Let’s assume you sell the stock upon receipt to fully close out the transaction.  This is immediate economic reconciliation.  Your loss on this sale is $500, against the $100 premium received.  This was not a good trade.  Here’s the accounting:

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You’ll note in the table above that just before expiration, the value of the option is -$500. Just before expiration, there is no time value left in the option, it’s all intrinsic value, i.e., the difference between the price of the stock and the strike price (times # of contracts x 100 shares/contract).   That’s a $500 intrinsic value to the buyer (and therefore a negative $500 to the seller).   You could avoid a realized loss on the sale of the stock put to you by buying back the option just before exercise (presumed to occur at expiration), but then you’d have that same realized loss on the buy back of the option (but then with no stock put to you).  There’s no avoiding market reality.  Now you could wait to sell the stock and hope that the stock price recovers, then sell it closer to or even above breakeven (or slap a call on it).   I call this delayed economic reconciliation.  But then you have dead money (other than any dividends the stock might pay) in the interim that can’t be used for selling options.  This was a bad trade.  They do happen.

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Let’s consider what we’ve learned from this simple example, before we move on to calls. In no particular order:

You can lose more, far more than you receive in premium, if the market goes against you and the stock is put to you and you sell it at a loss or if you buy back the option at a loss to avoid the put.  If the put is exercised, you can either recognize the loss immediately, or hold onto the stock and hope for better days.  Either way you’ve lost.  So, the timing of trades is important and the quality of the stock against which you sell the put is important.   Don’t sell put options on turds. You might wind up owning the stock for a while.   And the structuring of the trade, of the option contract, is important.  For example, this was an at-the-money option.  But there were other contracts available at the time of the trade, some in-the-money (with a strike price higher than the market) and some out-of-the money (with a strike price lower than the market).   Out-of-the-money options will pay less premium, but have a lower chance of being exercised.   The inverse is true.  There were also options with other terms-to-expiration (TTE) that we could have sold.  Longer TTEs garner more premium, but have more risk of being exercised.  And vice versa.    It turns out there’s a sweet spot regarding where to set the strike and where to set the term to expiration, and we’ll use the model to figure these out for us. 

We also learned that the prospective annualized return for selling a put option contract is not necessarily what you’ll wind up getting.  You only receive this return if the put option goes to expiration, and expires worthless.  Strictly speaking, you only realize the period return.  To realize the implied annual return, you’d have to roll this trade for a year at the same period return each time.  If you buy it back, your realized return will be different.  If the option expires in the money, and the stock is put to you, your realized return will be different.   In the case of the stock being put to you, depending on where the market is when the option expires – how much lower than the strike – the loss on sale of the stock may or may not wipe out the premium you received.  In this simple example it did, but that’s not always the case in real life.  But, you’ll have at least a reduction in the return. 

We learned that buy backs can be a good thing.   What we care about, ultimately, is the product: return per trade X number of trades in, say, a year.  We are largely indifferent between 1 X 10%, 2 X 5%, 4 X 2.5%, etc.  You should happily take less than 100% of the premium you’d get by letting the option go to expiration and expiring worthless, if you can get much of it early and put the released cash back to work sooner.  Here again details matter and again there’s a sweet spot, an optimal buyback return that the model will discover for us.  

It may not be obvious, but we also learned that selling puts on a secured basis is not much different than buying stock outright as you might normally do.  You have the same market risk to the underlying.  You could have bought the stock at $10 instead of selling the put.  Two months later, it would still have been worth $5.  By using the option to buy the stock, your loss is mitigated by the amount of the premium.   Here, the key is that you sold the put on a secured basis.  The technical name is cash secured put, but you can also use the term “covered put”.   It’s the only way you can sell puts in an IRA; no naked put selling in an IRA.   But here’s the beauty of it: when you sell the put, Fidelity (any broker) automatically secures cash in the amount of the strike price/share x the number of option contracts x 100 shares/contract.   This cash is unavailable to you, you can’t accidently trade using it.  You don’t have to worry about margin calls if your option goes in-the-money.  The cash needed to pay for the stock, should the option be exercised against you, is there.  It all flows seamlessly.  You can sleep at night. This brings up a third way to view selling covered options: it’s a modest, low risk, extension of cash market trading, a way to generate some extra income via the option premium (or the buyback) – as long as the trade works out (or if it doesn’t, the premium buffers the loss you’d otherwise have had). 

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Now let’s discuss calls.  They’re a little more complicated because to sell a call on a covered (secured) basis – which again is the only way you can do it in an IRA – you need to first own the stock.   This situation is analogous to put selling, except there’s a specific stock rather than cash securing the call you sell.  And rather than the three possible outcomes we had for puts, there are four potential outcomes to consider for calls.

Here’s the fact set for a simple call example: 1 call contract, struck at $10/share, with a cost of $1/share.  Assume the underlying stock price is also at $10/share, so the option is struck at-the-money.  Also assume the term-to-expiration of the option is 2 months.   You can readily calculate that 1 contract will require the securing of $1000 cash (1 contract x 100 shares/contract x $10/share of stock price).  Notice that for calls the stock price, not the strike price, determines how much cash is secured – by virtue of buying the underlying stock upon which the call will be sold.  Again, calls are not secured with cash, but rather with the specific stock.  In the case of covered calls, once the call is sold, the underlying stock becomes unavailable for sale until the call is either bought back or it expires worthless.  Further, you can readily calculate that $100 premium is received (1 contract x 100 shares/contract x $1/share).  On a base of $1000 at risk, over a term of 2 months, this provides a prospective period return of 10% ($100 / $1000), and a prospective annualized return of 60% (10% / 2 month TTE x 12 months/year).   Again, this is just an example.

Here’s how the accounting looks a nano second after you pull the trigger on the trade:

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You’ll notice that when doing calls, we have an additional entity to concern ourselves with – the purchased underlying stock.

Now, let’s consider a simple outcome for call options, when it expires in-the-money.  This occurs when the underlying increases in value above the level of the strike (let’s say for this example to $13/share), but not by enough to warrant buyback of the pair (option plus underlying).   With the underlying increasing in value, your short call will increase in negative value.  The underlying and the option will directionally offset one another.  But depending on how much time value remains, and how the implied volatility for that option is changing, the gain in the underlying may be significantly larger than the loss in the option or vice versa.  So sometimes it does makes sense to buy back the call, and sell the underlying, for a net gain on closing out the trade.   Sometimes, though, that would result in a loss or an insufficient gain to justify the unwind (i.e., the return is below the pair buyback return hurdle).   We’ll assume for this case that the pair is not bought back because the gain on closeout is not over the return hurdle.   I’ll say more later about how this hurdle is determined in the parameter optimization page.  

So in this case, the buyer of the call will exercise his right, and take your stock from you, giving you in exchange the strike price (times # contracts x 100 shares/contract).   Any increase in the price of the stock above the strike price, which in this case is also your purchase cost (BV), is forfeited by you.  This forfeiture is not an economic loss, it’s an opportunity loss.   But, you get to keep the premium.   It’s a good trade.

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The option is gone (exercised), and so is the underlying stock.   Since you didn’t buy it back, there’s no cash outflow.  You keep the entire premium that you received, and your realized gain is, accordingly, the full $100.  But you didn’t get the $300 gain on the stock; that goes to the call buyer.   Again, you don’t have a realized loss, but there was an opportunity cost for doing this trade.  Still, you’re ahead by $100, and with a pretty good realized return on your risk (60% annualized).  You could have bought back the option just before expiration, but that would have cost you $300 – the intrinsic value.  But then you would have kept your stock with unrealized gain of $300.   So once again, there’s no hiding from Mr. Market.  Notice also the importance of structuring this trade, and think about what the result would have been if you had set the strike below your purchase cost.  More to come on this point when I discuss parameter optimization. 

Next, let’s consider the situations where the price of the underlying decreases.  The first one is where the call expires worthless, and the stock is not taken from you.  The only reason the stock wasn’t taken from you is because its price is at or below the strike price and you didn’t buy back the option only, because it wasn’t over the its buyback hurdle.   Let’s say its price decreased to $5/share.

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You got to keep the entire $100 premium, your stock (the underlying) was not called, but now it’s underwater by a considerable amount: – $500.  This is an unrealized loss, unless and until you sell it to recycle your money into new trades.   Or you can hope for better times and a sale closer to break even, but have dead money (other than dividends) in the meantime.  Bottom line: your timing on the purchase of the stock was bad. Consider, though, if the stock had merely declined to, say, $9.5/share, giving you a $950 value for your holdings.  This is an entirely different situation.  You are now only a little bit underwater.  You could do an immediate economic reconciliation, take the $50 loss on the stock sale, and still be ahead $50 on the trade.  This would give you a pretty good 30% annualized return.   So, again, timing of the trade matters.  A lot.

Now for the buy back situations.  For calls, there are two such situations.  We briefly discussed one of them earlier: the pair buyback.  This situation occurs when the value of the underlying increases sufficiently more than the negative value of the option increases, such that buying back the pair (the underlying and the call on it) and fully closing out the trade is attractive.   There’s a sweet spot for when to do this: a pair buyback hurdle.  This situation occurs quite frequently, and it’s due to a combination of decreases in implied volatility from when the option was struck, and theta decay, such that the option doesn’t become proportionately as expensive (more negative) as the stock increases in value.    Here’s how the accounting looks:

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This is a pretty tasty net gain; you’d be happy to do this all day.  The sooner after the trade you can do it, the more quickly you can recycle your money.  Wash, rinse, repeat.

The second buyback situation occurs when the value of the underlying decreases, and the negative value of the option decreases sufficiently that buying back the call only is appropriate.   Depending on how your calls are structured, and how your trades are timed, this situation can occur frequently.  It is not ideal, however, since once you buy back the call you are left with an underlying that is underwater.  It’s dead money, other than for dividends.   In all the modeling I’ve done (The Code), I have never found this to be an optimal outcome.   Dead money is to be avoided; it’s a loser except for situations where the stock price pops back up quickly.  But there’s no predicting that.   Here’s how the accounting looks:

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Let’s consider what we’ve learned from this simple example.  Again, in no particular order:

Everything we learned about puts applies to calls as well.  Don’t do calls on turd stocks; unlike puts where you might wind up owning the underlying, in the case of calls, you need to own the stock before you can sell the call on it.  Timing and structuring of the trade are just as important for calls as for puts. There’s even more clarity in the case of calls: it’s a rare situation where it’s smart to set the strike below the purchase cost of the call.   You’ll get more premium by doing this, but you’ll have a realized loss if the stock is called.  And the loss almost always exceeds the premium.  It’s almost always best to set the strike at or above the purchase cost.  The model will help us decide more specifically. 

Once again, prospective return is only that: prospective.   How Mr. Market unfolds, and what actions you take (buyback or let it expire) will determine realized return.

As for puts, there’s a buyback hurdle.  But for calls, it’s for the combination of the option and the underlying.  Buying back the call only is not optimal, because you have dead money in the form of an underwater underlying.  The model seeks to structure and time call selling so as to avoid this situation. 

We also learned that selling calls is not unlike a cash market trade.  In fact, as we’ve mentioned, you actually have to own the stock before you can sell the call.  And again we’ve seen a third way to view the call sale is as an extra source of income on the stock.

Calls are relatively more complex to think through than puts, because you have the underlying to consider.

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Before moving onto trading (timing and structuring particulars) or modeling of the trading process, I’ll go through a few more option basics.  Early in the life of a call option, there is considerable time value – the price of the stock may keep going up.  If the price of the stock is only, say, a little above the strike price, the call option is unlikely to be exercised.  But the more the stock price exceeds the strike price (the difference is called the intrinsic value), and the closer expiration approaches (so time value decreases), the more likely it is that the call buyer will exercise the option.   Put options behave inversely to calls, except you receive no dividends.

Rarely is there a free lunch in investments.So what is the incremental risk of trading covered options (being an insurance salesman), given the juicy prospective premium?  Once you sell the call, you are locked into potentially losing the stock at that strike price at someone else’s discretion.   As time unfolds, you might realize you’d rather sell it at a higher price than the strike.  Maybe you have a sudden need for liquidity, and you’d be happy to take a lower price than the strike.   But you can only change your mind and implement a different sell price if you close out the option.  And you can only close out the option by buying it back at the prevailing market price, which might be higher (substantially higher even) than the price at which you sold it.  Since you’re short the option, this is not good.  So, while you’re not irreversibly locked in, there might well be a significant cost to getting out.  [Note: it still may make sense to get out.]  So even though you can get out of an option, it behooves you to be very clear on the strike at which you are happy to sell a given stock and to plan on sticking to it unless a favorable buy back opportunity emerges.   Puts have similar considerations.  Once you sell a put, you are locked in unless you buy it back.  And you may have to pay more to buy it back than you received in premium. 

I often say, with respect to active trading, that volatility is your friend.  It generates that nice quasi-sinusoidal pattern that allows you to buy stocks low and sell them high (or in the case of options, sell high and buyback low (expire at zero).    This pattern does not always occur and certainly not perfectly, but well enough and often enough to make good money vs. a buy and hold strategy.   Well, volatility is your friend here too.  But you have another friend, maybe an even better one.  Time.  As an option seller, time is on your side.  Yes it is (apologies to the Stones).  As we’ve seen, you receive the full premium, but there’s an offset on your brokerage statement in the form of a negative option market value (negative because you sold it – it’s a short position).  This offsetting market value will fluctuate as market conditions change (implied volatility and the underlying stock price), but the trend has a downward bias due to theta decay – time value decay to zero at expiration.  Since you, as a seller, are short the option, a downward price bias is a good thing.   The buyer of a naked option lives in panic that the market will move against him, and he’s always fighting time – theta decay – hoping his option doesn’t expire worthless.   Everything has to go right for him to make money.  Everything.   

As a seller of covered options, on the other hand, you don’t really care.  You can relax and go have a beer and crab dip with pita chips, by the pool.  If you’ve set your strikes at the right level, and have quality stocks, and even a little edge on timing, you’ll likely win.   You’ll always get the premium.  You’ll wind up, in the case of a covered call, maybe having the stock taken from you – but receiving in return the proceeds at a strike that builds in the gains you wanted, along with interim dividends.  Or you’ll keep your quality stock, again, along with any dividends generated in the interim.  In the case of a covered put, you’ll maybe have cash taken from you and receive a stock you wanted at a good entry price.  Or you’ll get your cash back (i.e., freed up, unsecured) at expiration.   Either way is fine.   And if you’re lucky, and nail the sale of the option, you might be able to buy it back at 60 to 70 cents on the dollar in a few weeks (rather than waiting a few months for expiration or exercise), and then play the game again.  Wash, rinse, repeat.   More on this in a bit.  

I close this section with a brief mention of a third friend (volatility and theta decay being the first two): the empirical observation that most options are not exercised by the buyer until expiration or very close to expiration, almost no matter how in-the-money they are along the way.  This provides you, the seller, with breathing room to let time and the market work in your favor.   Many is the time I’ve sold an option, only to have the market move against me and stay that way.  MACD, which the technical indicator I use to help time the trades, is hugely helpful, but it’s far from perfect.  Every day I expect the option to be exercised, but it’s not.  And then as luck would have it, there’s that volatility again, the market moves in my favor as the clock ticks down towards expiration.  Why the options aren’t exercised when they could be (after all, these are American, not European, options – they can be exercised anytime) is one of life’s mysteries.  But it’s a reality nonetheless that is very much in the option seller’s favor.  It makes for a very forgiving process.

Next in sequence: Option Trading: The Concepts

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