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ON MONEY: Profit from the sale of derivatives | Characteristics – BollyInside

The right to transfer ownership of stock shares can potentially provide additional investment opportunities to investors in the form of derivatives. A derivative is “a financial security with a value that is reliant upon 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.” As an example, Wells Fargo was ordered to pay $575 million in 2018 to settle a shareholder class-action suit for what were deemed unscrupulous sales practices.

Assume that you believe that the price of ABC stock, currently selling at $50 per share, is destined to go up in the next few months. You purchase a call option with a strike price of $52 which will expire in 3 months. You pay $2 per share or $200 for this call option.

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

Fast forward 85 days and the current price of ABC has risen 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 stock. You paid $5200 for the stock plus the option price of $200, but you sold the stock for $6,000, netting a tidy profit of $600. Had ABC remained at $52 per share or had gone down in price, you would be out the option price of $200.

Moreover, you are not obligated to buy and sell the actual ABC stock since you can simply sell the call option yourself. The then current price of the option itself would have risen to $800 and you would net the same profit.

If you owned 100 shares of ABC, you might choose to sell a call option on the shares that you own. This transaction is known as a covered call. When the option sale is consummated, you have the $200 (known as the option premium) in your pocket. If the stock price rises above $52 within the expiration period, you must relinquish the stock at the agreed upon $52 sale price. If you had purchased ABC for less than $52 per share, you would have a trading gain of $252.

If the price of ABC did not go above $52 prior to the expiration date, you would still own the stock and the $200.

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More than a few savvy investors use this covered call approach to provide income from their portfolios. Should you decide to get your feet wet by utilizing covered calls, it will pay you to thoroughly educate yourself on the nuances of such a strategy.

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