In this video, Achievable author Brandon Rith picks apart an options income strategy (covered calls) question for the FINRA SIE. He breaks down each part of the problem and how to solve it in a straightforward, easy to understand way using a real world example.
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0.0s Let's take a look at an income strategy, question together. Pick it apart. See if we can look at the inner workings of what's going on. So we can understand overall, how to approach these strategies and how to consistently get test questions on them. Correct. Alright. In January and investor buys, 100 shares of PDQ stock. When the market price is 60, after a few months, the stock price close to seventy the investor believes. The market will not rise above 75 by the end of October to take advantage. They go short one PDQ October 75 call collecting a $400 total premium. Okay there's a lot given in this question kind of a story that they presented us with here. If you happen to get one of these longer questions on the exam just hang in there. Take your time, breathe. It's going to be okay. 56.9s In reality, there's there's only a couple things that happened here that are important, although there's a lot more language that's added that might make it seem like there's a ton more going on, essentially given investors bought shares a PDQ socket 60. And then later after the market price Rises, they sell or go short a October 75 call. This is an income strategy, specifically, a covered call. Remember a short call has a limited risk potential as a standalone, single leg strategy. If that's any 5, call is all by itself in the market price Rising significantly. It's a up to 1,000 the investor has an obligation to sell stock at 75. They have to go to the market. Buy stock in 1000, sell the stock at 75 through the option, being exercised and lose a ton of money if that were to occur, but the call is covered by virtue of the investor owning the shares of stock already. They don't have to go to the market to buy shares to Dubai. 116.9s Deliver them at 75 or sell them at 75. Now, as the name suggests, this is an income strategy and investors looking to create additional income, specifically, by selling Bacall, the call is not the primary focus for the investor. This stock is the stock is really their money maker. 138.2s But investor would entertain the idea of an income strategy. If they were to think the market price for the stay flat over the next short-term. In this case here until the end of October Best Buy stock at 60 McCoy drive, 70, probably feeling pretty good about themselves but hey, maybe in the next few months, I just don't think the stock prices going to go up. 75, somebody selling a 75 call. They've essentially put a ceiling above themselves as 75. Remember call up put down, call up. If the market price rises above 75 that call is going to be exercised, forcing the investor to sell their stock at 75. Remember what a short call is the obligation to sell. Now going to the second question, what is the market sentiment? Which just means what what is the investor? Hoping a pint? 186.9s And this is a tough question to answer with any multi-part option strategy that, why bolt for a long stock, which is bullish or shorter call, which is bearish market. Price of all the best way to think about an income strategy is to prioritize and focus on the stock position. The stock is really what the investor cares most about and of course an investor that's longstock once the market rise. Their bullish. But the problem is, we've got a call that they'll just hate the market. Price goes above 75 walking to get exercise and we're just going to sell our stock of 75. So we put the big picture together. This is really a bull neutral strategy. Probably say, mostly neutral. The investor here is selling the call for two reasons. Number one, they're making a premium off of the option. It has money in their pocket. Number to, they don't think the market price is going to rise significantly. 243.0s If he thought there was a chance at the market price, going to rise significantly the hundred 150 or there's just a lot of upside potential in the short-term selling the call would be a bad move because again, yeah. But the call is going to give you some money from selling the option and give you that premium. But if the marketplace were to rise, say the 150, investor would have made a lot more money. If they hadn't sold the car and that's why I will call this a bull neutral strategy once we go through some of the numbers below. I think the big picture will start coming together. Let's take a look at our handy-dandy T chart which is not an absolute necessity to answer these questions correctly, but a lot of people like T charts, especially visual based Learners. And I myself because they help me keep the numbers straight and therefore I don't have a bunch of numbers swirling around my head that I might forget or not. Keep track of this is how my teacher always looks. I have a plus and minus column on the left and right side. 303.1s Plus would be for money in. Might as well be more money out. And then I have an option and a stock row, let's go ahead and fill out RT chart. For what we have just based upon within the question. Now, the investor buys 100 shares of PDQ stock at 60. And without information, I'm going to plug a 60 on the minus column in the stockroom. I personally like using the small number spending $60 per share, instead of paying 6,000 there, could you put 6,000? Absolutely go with what, whatever way works best for you. The only thing you have to remember those, if you use small numbers like me, you just got to remember to multiply it times. In this case, 100, at the bottom or X Harmony Shares are involved. If it was the three hundred shares and three calls that were sold in the questions, we need to multiply times three hundred at the bottom, just got to remember that one part. So again, we have a 60 in the minus column in the stock rope cuz we bought stock at 60, that's money. Out of my pocket. We will also pull 363.1s And a 4 on the plus column in the option, bro. And that's because we sold that option for a total for $2 premium on a per-share basis that would be for. Now, some of you might be asking, wait what about the 75 the 75 is the strike price which may or may not come into play. If the option is exercised, the courts will plug 75 into the T chart. If it goes on exercise them it won't go in there. The only thing that we can say affirmatively is that we sold an option and collect $84 per share premium, and that's how RT chart will look and start with every single math. Question that we come across a 60 in the minus column of, for the plus call great. Now, let's go to maximum game. The best way to think through any of the potential maximum potential, gains worth potential losses, even break. Even the best way to think about this is to use the stock as our starting point in the stock will really Define where we want the market to go. 423.1s Somewhere. We don't want the market to go. So we think about it, okay? I'm long stock. Longstock is a bullish strategy, which means we'll make money at the market price, for the rise, can the market rise? Infinitely? Is there any ceiling to the market? No marking, can go up up up up. So, we think about that, sometimes it's easy to pick a number, just go with an absurd number. Same market price Rises to a thousand that be great for the stock position. But we have to make sure that we're keeping in mind what would happen to the option in that scenario and 1,000 the call is deep in-the-money call up, remember. Paul's get exercise if the market price Rises up above the strike, price in 1004 technically new price about 75. Call is in the money. It has intrinsic value which just means in a nutshell. It's going to get exercised. Most of the time when you're short Notch and you don't want that option to be exercised. And in this case, 483.0s At the market price were to rise to a thousand. Really hope that we didn't get exercise. But the reality is exercises going to happen. Call will be exercised with the person that bought it for seeing the investor to sell stock at 75. And we'll plug that in will put a 75 on the plus column in the stockroom. 505.2s And from that point, we just need to add up all the numbers. That's the end of the story, we have a 4 and a 75 on the plus side, to get it at 79. We have a 60 on the minus side. We met those out together. That leaves us with 19 on the plus side, x x 100. It's a $1,900 maximum gain and that's why this is a bull neutral strategy at the market price for the rice and the call gets exercise. Take the investor is still making money there. In fact, they're going to make their maximum potential game. What did the market price goes in a 75 or 1000 or anywhere above 75? Their their maximum potential gay. The market price for stay relatively flat? Stop investor would make money on the side position. Plus the premium together hopefully that helps paint the picture as the wide is a bull neutral strategy. Let's go ahead and reset the T chart. We still have a 60 on the minus side and a four. 565.1s On the plus side now maximum loss, we will think about who the same length as we did with maximum gain. Remember the stock is the primary focus of the strategy from longstock? Where's my maximum lost to be with the market price Falls? And we don't have to thank me. We'll just have to pick a number out of thin air here. Zero is worst case scenario for us. Position in the market price for all the way down to zero. We would lose all the value of our stock. Which would it be good. Now, the only other thing we have to ask ourselves what happens to the option in that scenario can market. Price Falls all the way down to zero. Call up, put down up to the Mark Price. Go up above the strike price now and zero really any price below. 75, B option is out. The money has no intrinsic value which just means it's not going to be exercised, it will expire worthless. Now there's a small good from that in a big bathroom that the small good is 625.1s Keep the premium, that's easy money. Don't have to do anything. Now, the big bad part of it is the stock just lost a bunch of money in the option is not helping us here. There's one last step to our teacher. It was really just be kind of putting in a useless number. If we were to sell the stock at zero, I would put a 0 on the plus side. If we just want to complete the teacher and that would be the end of the store. So we'll stop for nothing. So we end up with a four. On the plus side is 60 on the minus side that leaves with 56 left over on the minus side x 100, that is a $5,600 maximum loss. Of course, this is not a hedging strategy options, not there to protect the investor, but I do want to point something out. Some people call this type of strategy a partial hatch know, why would be calling a partial hedge? Well, let's think about it. If we bought stock at 60 in the market price, for the go all the way down to zero. That's a $6,000 loss there. 685.6s But by selling the call that put 400 extra dollars in a Buster's pocket, which reduce the risk level overall. So could it be argued the call acts as a partial Hedge? 699.0s And sometimes investors will even look at this as a way to justify that, it cover call is actually a really safe strategy. If I were to compare the stock position, to the stock position. With a short call the short call added into the mix. Reduces overall risk for the investor, which is why if we have an investor that already own stock recommended they sell a call, I can set stock is really not introducing much risk at all. In fact, it's the opposite. It's reducing overall risk. And from a suitability standpoint, you might even see a test question, where you recommend a cover call thuy more safe or conservative investor. So the stock position is really where the investor is absorbing race car facing risk. The short calls not introducing risk. In fact, again last time I say it it's reducing risk overall, for the Ambassador and putting money in their pocket, all that in exchange for putting a ceiling above themselves at 75. Let's go ahead and wipe the future clean. 758.9s We still have a 4 on the plus side, a 60 on the minus side. And we get the break-even break-even is always my biggest selling point to using a t-chart. Now, this will work for any hedging or income strategy that you come across. If you can get to the point where you feel comfortable enough with just filling out the T chart for what happened in the question, in this case, here, we have a 4 on the plus side, the 60 in the miticide, there's only one question. We have to ask ourselves to answer break even and that is what. Number could we introduced? That would give us a balance out T chart and particular where would the stock price need to go to give us the same number on both sides. 801.1s There's only one answer to that if 56 is plugged into the stock row on the plus side, we end up with 60 on both sides and that is our break even T charts are great for break-even questions because there's only one number. We could plug in that would get us a balanced out teacher now let's think about this a little bit more. Conceptually the investors sold an option for a total of $40 premium and if they were to buy stock at 60 and then just sell this called, hey, if the marketplace were just to stay flat at 60, they're still going to collect that $40 total premium and there's something we dropping at that point. So maybe one way to think about this is if I sell an option against the stock position, I will break even only at the market price Falls by the amount of the premium. I collected. If I lose $4 per share in the stock position that will offset the $4 for sure I made by selling the option. So for those of you who like formulas by the way, I'm not a big fan of formulas for options just cuz there's a million of them but with a covered call, 861.1s The price of the stock is purchased, at minus the option, premium on a per-share basis. Will tell you break. Even every time, let's go and wipe the teacher. Clean still have four on the plus side. 60 + 2 - 4. The last few questions This Is Us. Think if they're okay, let's say the market price goes here. What would be your gain or loss? So, think about what happens Marketplace goes to 77. Okay, think about the stock first has its 77, that's good for the stock pot stock at 60. Goes up to 77. That's a $17 per share gain. We're pretty thrilled with that, but we can't forget about the option. 900.5s It's 77th. There's only one question to ask yourself is the option getting exercised. 907.0s Call up market price. Goes up above the street. Price of 75, the option will be exercised. Are we there? Yes, the call will be exercised. So this case here at 77 and matter could be 77. He could be 88, it could be five thousand. Doesn't matter that calls going to get exercise for c b ambassador to sell their stock. It's 75. So we put a plus 75 on the stock bro, and that's the end of the story. Feels pretty similar to maximum gain, right? We end up with a 79 on the plus side is 60 and the Midas I'd end up with a 19 left over on the plus side. * 100 gives us to a $1,900 gain. Last question, I lost it 40. 954.0s All project pretty similar to the last question. Think about the stock first, okay? If I bought stock at 60 market price falls down to 40. That's a $20 per share loss. Next thing we got to figure out is what happened to the option? Will it be exercised? Call up, did the market price? Go up above 75 know, the calls out, the money has no intrinsic value inn at 40, we can assume it'll Inspire. So if this is the end of the story here in duster is just going to be selling their stock 4:40. So we'll plug a 40 on the plus side in the stock row without a phone numbers of a 44. In the plus side is 60 in the minus side that leaves. It was 16 left over on the minus side. 1000.7s Has a hundred with a $1,600 loss.