ON THE MONEY: Profiting from the sale of derivatives | Characteristics

When a person owns shares of a company, these shares represent the participation in the capital of a company divided into units so that several people can each own a fraction of a share of that company. If you are a shareholder, you have certain property rights. These rights include the ability to vote on various business matters, such as the election of a board of directors; the right to transfer your inventory by donation or sale; the right to share in the profits of the company if the board of directors declares a dividend. You also have two, perhaps less valuable, rights: the right to inspect the books of the company, if it is publicly traded, and the right to sue the company for its wrongdoing. This right generally takes the form of a class action.

As an example, Wells Fargo was ordered to pay $ 575 million in 2018 to settle a shareholder class action lawsuit for what were considered unscrupulous sales practices.

The right to transfer ownership of shares can potentially provide additional investment opportunities to investors in the form of derivatives. A derivative is “a financial security whose value is dependent on or derived from an underlying asset or group of assets — a benchmark. The derivative itself is a contract between two or more parties, and the derivative derives its price from fluctuations in the underlying asset.

One type of derivative is the call option. These are financial contracts that give the buyer the option, but not the obligation, to buy an underlying asset, such as a stock, fund, or commodity, at a specified price, called strike price, within a specified time frame or expiration period. A single stock option is based on 100 shares of the underlying stock.

Suppose you think the price of ABC stock, which is currently selling for $ 50 a share, is destined to rise over the next few months. You buy a call option with an exercise price of $ 52 that will expire in 3 months. You pay $ 2 per share or $ 200 for this call option.

Fast forward 85 days and the current price of ABC has increased to $ 60 per share and you decide to exercise your option. The seller of the option is required to sell you the 100 shares at $ 52 per share and you immediately sell the share. You paid $ 5,200 for the stock plus the option price of $ 200, but you sold the stock for $ 6,000, making a net profit of $ 600. If ABC had stayed at $ 52 per share or had fallen in price, you would have exceeded the option price by $ 200.

Additionally, you don’t have to buy and sell the actual ABC shares since you can simply sell the call option yourself. The then current price of the option itself would have reached $ 800 and you would have made the same profit.

If you owned 100 shares of ABC, you could choose to write a call option on the shares you own. This transaction is known as a covered call. When the option sell is consumed, you have the $ 200 (called the option premium) in your pocket. If the stock price exceeds $ 52 during the expiration period, you must surrender the stock at the agreed sale price of $ 52. If you had bought ABC for less than $ 52 per share, you would have a trading gain of $ 252.

If ABC’s price did not exceed $ 52 by the expiration date, you would still own the stock and the $ 200.

More than a small number of savvy investors use this covered buying approach to earn income from their portfolios. If you do decide to get your feet wet by using covered calls, it will pay off to educate yourself on the nuances of such a strategy.

I found this source useful: https://www.fidelity.com/learning-center/investment-products/options/generating- Income-with-covered-calls / overview

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