Yahoo Finance works pretty well as a place to gather information. If you can input a ticker symbol, you can get information on options. After entering “TGT” the basic summary page will come up. The third selection down is “Options.” Here’s what that looks like:
When you click this link you’ll be directed to Target’s option page. Just above the tables you’re able to select the expiration date that you would look. Below I have selected January 20th of 2017:
Note that I have no affinity for this expiration date, but it will make the demonstration relatively straightforward.
The first tables list ‘call options’. The second set are ‘put options’, which we’ll leave for a later explanation.
The left-hand side starts with the strike price, followed by the contract name, last price, bid, ask and some information about that particular option:
When you’re looking at selling call options you’re thinking about at what price you’d be happy to sell. Naturally this may be a new concept (as Warren Buffett would have it, “my favorite holding period is forever”) but remember the underlying goal: to both own shares and increase your cash flow.
This is an individual process, but I’ll pick a number to continue the demonstration. Owning shares of Target with a P/E ratio of 15 or 16 seems rather reasonable and you might be happy to hold at this valuation. Yet if shares traded around say 18 times earnings, you might not be as enthused. This would equate to a future price of about $95. We’ll use that as our baseline: we’re happy to hold, but also happy to sell should shares increase to $95.
If you wanted to make this agreement, you could sell the January 20th 2017 call option with a $95 strike price. In return for agreeing to sell at this price, you would receive a premium. As I write this the premium sits at $1.20. We’ll call it $1.10 to account for fees and fluctuations.
Option contracts are expressed on a “round lot” basis, or 100 shares. One contract is equal to making an agreement for 100 shares. So in this instance, you would receive ~$110 for agreeing to sell 100 shares of Target at $95 ($9,500 total) in the next 10 months.
Once you make the agreement, one of two things happens: either the option is exercised or it is not.
Let’s look at the first possibility.
If shares continue to trade below $95 it’s unlikely that the option will be exercised. (Why buy from you at $95 when someone can just go to the market and obtain shares for a lower price?) In this scenario, you keep your 100 shares of Target and continue to receive the dividend payments just as you normally would. The only difference is that you also received an “extra” ~$110 in upfront option premium.
You’d anticipate receiving say $225 (probably a bit more) in dividends to go along with $110 in option premium for a total cash flow of ~$335. This works out to a yield, based on today’s price, of about 4%. You achieved your goal of supplementing your dividend cash flow and still get to hold your shares.
A lot of people like to point out that selling a call option does not prevent you from seeing a loss, which is true. However, if the option is not exercised your return will be enhanced. Regardless of whether the future share price is $70 or $90, you already received the upfront option premium. You’re going to be $110 ahead if the option is not exercised.
Now let’s think about the second possibility. If the share price goes above $95, the option will likely be exercised. Note that it doesn’t have to be immediately exercised (or at all) but if the share price ends “in the money” it certainly will be.
In this case you still have your ~$110 in upfront option premium. You would receive a cash payment of $9,500 (less frictional expenses) for your 100 shares. In addition, you may collect some or all of the dividend payments for the year depending on when the option is exercised. In this scenario your total cash received will likely be somewhere between ~$9,610 and ~$9,835.
