What is an Option?

A stock option is a contract that provides the holder the right, but not the obligation, to buy or sell shares of the underlying security at a specified price on or before the expiry date. At expiry the option ceases to exist. If the option is exercised the seller of an option is obligated to sell the shares to the buyer of the option at a specified price. Call options are generally bought by investors who believe the underlying stock will increase in value before the call expires, as it gives the holder the right to buy the underlying security. Conversely, put options are generally used by investors who believe that there will be some downward pressure on the underlying stock, as it grants the holder the right to sell the underlying security.

Several factors that contribute to the value or price of an option contract are the price of the underlying stock, followed by volatility of the underlying stock price, time remaining until expiration, dividends and current interest rates.

There are many different strategies available to investors which employ the use of options. Quadravest Capital Management employs a covered call writing strategy which entails selling a call option against a stock (or long position) in the portfolio. This enables us to enhance returns to the portfolio by receiving a premium for this obligation. In addition, it protects the portfolio against a decline in the stock price (limited only to the amount of the premium). Covered call writing strategy is a more conservative approach then owning the stock outright because the investors downside risk is offset to some degree by the premium the investor receives for selling the call.

As a covered call writer you must be prepared at anytime during the life of the option to sell the stock if you are exercised. In this case your proceeds are limited to the strike price plus the option premium. It is possible to close out the option position by repurchasing a call in the same series.

The profit that is made by the covered call writer will vary according to whether the option was written at-the-money, in-the-money or out-of-the money. The maximum net gains for a call written at-the-money (strike price is equal to the current trading price of the underlying position) will be limited to the premium received from the option. For a call written in-the-money (strike price less the current price of the underlying stock), the maximum gain is the premium minus the difference between the stock purchase price and the strike price. An out-of-the-money (strike price is greater than the current price of the underlying stock) call is limited to premium plus the difference between the strike price and the stock purchase price only if the stock price increases above the strike price.

Terms

Underlying Security:
The specific stock that the option contract is based on.

Strike Price
(or exercise price):
The specified price at which the underlying shares can be bought or sold

Premium:
The price the option buyer pays for the right to buy or sell the underlying security, the premium is paid to the writer (seller) of the option.

Volatility:
The relative rate at which the price of a security moves up and down, this is found by calculating the annualized standard deviation of a daily change in price.