#1 Did you get the ‘write’ concept?

by admin on February 27, 2012

As I was asking my wife for comments on my previous posting, she mentioned that she still did not quite get the full picture.
Therefore I decided to craft out some imaginary example to illustrate the option selling strategy.

As a side note, selling option can be said to be writing an option.

However I must agree that my wife did not read up any material at all thus she is still confused. 😀
That is why I do urge everyone to read up on the following books to get a better understanding:

– Getting Started in Options, 3rd Edition
Michael C. Thomsett

– The Complete Guide to Option Selling
James Cordier and Michael Gross

Options on Property

Let’s say you stay in a district whereby there is a high demand for the property and the price is around $100k when you bought it. One day you saw an ad whereby there is a buyer who is willing to pay $200k to purchase the property but is only willing to buy in 3 months time. In order to grab hold of this great opportunity, you can sign a contract with this buyer to give him an option to buy your house in 3 months time at $200k. As the buyer is not obligated to buy in 3 months time, he will require to pay you let say $1000 for securing this contract.

3 months later, the property prices around your district is selling at roughly $150k. Since this price is lower that what the contract is offering (which is $200k), the buyer decided to forfeit his $1000 and buy from others in the open market.

At this point in time, you might be wondering who will be so foolish to pay $1000 to secure a contract to buy the property at $200k?
But if the property around your district is in such high demand and if the media is strongly advertising how good is your district, it would make sense to secure a contract to purchase at what the buyer would think is a fair value in 3 months time if he does not have the necessary cash available currently.

As the seller, you will not lose out in anything as not only you manage to secure a $1000 for doing nothing except signing the contract and waiting for 3 months, you can still choose to sell your property at $150k right now or wait to sign another contract to constantly generate an income.

From this example, you can see a few concept:
Underlying -> The property that you are selling.
Options -> The contract that you sign with the buyer who pay $1000 for it.
Covered selling of the options -> You own the underlying thus it is considered a covered selling. An example will be shown below if you do not own the property.
Strike price -> $200k.
Premium to purchase the option -> $1000.
Expiry -> 3 months time.
Spot price -> $150k.

Uncovered/Naked selling of the options

Some experienced investor who is monitoring your district for a while feels that the price of the property seems to be too high as a result of the strong advertisement from the media.
The investor decided to use the same method as you have done. He will search for any buyer that is willing to pay for more than the current market price of the property and is only willing to buy at a future date.
He will proceed to sign the contract with them (an option contract) and take the fees ($1000 from the example above) that the buyer is willing to pay to secure the option contract.

Now this investor is taking a slight calculated risk here as he does not own any property, for example if he sign a contract to make delivery for a property price of $200k in 3 months time, there can be 3 possibilities:
1) 3 months later, the market price is equal to $200k.
The investor will be required to deliver the property to the buyer if the buyer decided to exercise the option. If he did exercise the option, what the investor require to do is to just buy a $200k property from the open market and sell to the buyer at $200k so a loss of $200k (current market price) – $200k (strike price) = $0.

2) 3 months later, the market price is higher than $200k, let say $250k.
The buyer who managed to secure the $200k contract would be more than happy to exercise his option as he only require to pay $200k (due to his foresight) even though the current market price is selling at $250k. The investor will be making a loss $250k (current market price) – $200k (strike price) = $50k.

3) 3 months later, the market price is lower than $200k, let say $150k.
The buyer most probably would not want to exercise the option to pay $200k for a property since it make sense to buy from the open market instead as it is cheaper. The investor get to keep the premium (explained on the above example) that the buyer paid to secure the option and can continuously perform the same routine to generate a cashflow.

It may seems to be risking a lot ($50K) to get a premium of $1000 but if you look at the odds of losing, it is 1 out of 3 chance when the market price is higher than the strike price. And if you did sufficient research plus the fact that the price normally will not shoot up too drastically within 3 months, the odds of keeping the $1000 is even higher.

Of course this is a fake example but what I hope to achieve is the concept behind the option selling as being a consumer, we are too used to buying and not selling. The product (property in this case) can be interchanged with any product for example the strategy that I am using is mostly on commodities (corn, crude oil, wheat, gold, silver, etc.).
Feel free to comment to let me know how bad or good the above example can help you to understand the ‘write’ concept. 😀

Disclaimer: The author is not a licensed financial advisor and the information is provided for educational and information purposes only.
Trading commodity futures and options have large potential rewards but also contains a high level of risk and is not suitable for all investors.
Only risk capital should be used when trading futures or options.
None of the information provided constitutes a solicitation of or a recommendation to buy or sell any futures or options contracts.
Please seek the advice of a professional financial advisor before investing your money in any financial instrument.

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