Explain Out of Money Call Strategy

[JimInOK]

All right, I'm an owner of Ford Motor stock (F) and have a respectable gain in the position. An analyst today announced he thinks the price has risen too far too fast. It's sitting around $11.60 right now. He advises selling out of money calls on the $12 June strike price. I am not going to do it as I have no experience with this type of thing (I'll more likely sell half my position to lock in a gain and let the rest ride), but is there anyone here that can explain what your goal is in doing this?

What I know is that the $12 June call is going for about $1.20 now, so I know on a 100 share transaction (I'm guessing that's 1 contract?) I'd receive $120 less commissions. Questions:

Is my best case scenario that the stock remains where it is at now until the option expires so I can just pocket the $120 and still have my stock valued close to the strike price?

Isn't this a really risky play? My understanding is that the stock can move up a short distance and then the option will be executed, leaving me with a bit more than I already have now; or it can remain about where it's at now as in my best case scenario above; or it can drop significantly over the next 5 months leaving me with no way to sell and limit my loss until the contract expires. If this is correct, sounds like my potential downside is much greater than the potential upside. Wouldn't I be better off buying a put or, simpler yet, just setting a stop loss price that guarantees I retain much of my current gain while giving me the potential that the stock continues to rise?

Sorry, I know this is a long and complex post. I just don't think I understand all that goes into this.

[Broken Arrow]

Ok, maybe someone can give you a better answer, but for now, an option that's out-of-money is one that does not show a gain. In-the-money is when it does show a gain.

So, it seems to me that what your advisor is saying is that he suspects F will fall in the near term, in which case, it will only widen the losses on your out-of-money options. However, for the options you have that are in-the-money, you can afford to stay in and ride it out some more.

Whenever you're dealing with options, it's always kind of a risky play because there's a timer that's constantly ticking. You don't have the luxury to wait it out for some fundamentals to kick in.

And for that matter, F is a risky stock to begin with. In retrospect, sure, I wish I dashed for trash too because as professional traders like to say, you trade the market, not necessarily the fundamentals (or anything else for that matter).

But put the two together and, well, you do know you're speculating with something very risky right? I mean, I'm not against options trading or playing with F. I just think people should know full well what they're getting themselves into....

Unless I'm mistaken (and I could be), but I think your advisor is actually telling you to mitigate risk by locking in the losses before it gets any bigger (that he suspects they will become). And actually, it's not a bad time to sell right now. The Detroit auto show just ended, and F got a nice bump because their new re-designed vehicles won both the US Car and Truck of the year award. I'm also looking forward for their Fiesta to make it stateside. But unless your options have a LONG expiration date, I'd also sell.

Buy when the market tells you to buy, sell when the market tells you to sell. Believe it or not, but gains and losses shouldn't cloud your judgment in this matter.

[kv968]

Is my best case scenario that the stock remains where it is at now until the option expires so I can just pocket the $120 and still have my stock valued close to the strike price?

That is your best case scenario with selling a call although the option price can go up and/or down between now and the excercise date also depending on the price of the stock, volatility and time remaining on the option. Actually you would be better off if the price went down since the option would most likely become worth more. However with you actually owning the stock that wouldn't be good. IMO, if you really don't understand the way it works, you're idea of selling some to lock in a profit and letting the rest ride would probably be best.

[Slug]

You could always sell options at a $10 strike price. These in-the-money calls go for more of a premium, and since you're thinking of selling anyway, you really won't care if the shares get called. So, this is a way of locking in the gains you were talking about while protecting for downside risk. The risk instead that you take on is that you're giving away any upside because the call is already well in the money.

Additionally, after you sell your call, and the stock price drops, you can always buy your call back at a lower price and then exit the position while still retaining a portion of the stock gains and the option gains. This works better if you're sitting on lots of shares since the commissions will eat into your profits quickly if you only have 1-2 hundred shares of a non-volatile stock.

[JimInOK]

Thanks for the responses! Slug, appreciate your point about being able to buy the option back. Hadn't thought of that. As I said, I'm really just to trying to learn how this kind of an option play works. It was of interest to me right now simply because a columnist was using it in reference to a situation that applies to me.

Broken Arrow, yes, I realize the speculative nature of my position in F stock and I consider all options plays to be more in the nature of gambling than investing. The bulk of my retirement money is invested in index funds in a couple of 401k's. The money I have invested in F is part of an IRA account that is very small in value compared to the 401k's. I use this account basically for fun. I enjoy playing individual stocks, but I don't really want to do it with money I'm relying on. That frees me up to take chances. I've won big on some and I've lost big on others. It keeps me out of the tribal casinos that are so prevalent in my neck of the woods!