Options for Beginners: How to Pick Your Targets

For investors interested in using options, it's important to understand the underlying stock as well as the strategy in question. 

In this segment from Motley Fool Live that first aired July 9, Motley Fool Canada analyst Jim Gillies, Motley Fool Options advisor Jim Mueller, CFA, and Fool.com editor/analyst Ellen Bowman discuss finding the right company for the strategy you want to use.

Jim Gillies: I don't know what your strike price on your covered call [on Starbucks (SBUX 1.09%)] is here, Jim. Let's say it's a 120?

Jim Mueller: It is.

Jim Gillies: OK. So if Starbucks runs to 140, say, and your risk is essentially the $20 between the 140 stock price we've run to and a $120 strike price will be selling your shares to. The second caveat is, there exists, as long as the stock doesn't run too far on you, this is why we always said, if you're going to play with covered calls, covered calls are great strategy. I love covered calls. Pick your targets. Starbucks, good target. MongoDB, [laughs] The Trade Desk, bad targets. Do not write covered calls on something that has the potential to run away from you. I'm really

Jim Mueller: Though I have done so.

Jim Gillies: We've all done so, and that's why we say bad target. [laughs]

Jim Mueller: Well, if you go in knowing that this is a possibility, and you go in with the right mindset and the frame of mind.

Jim Gillies: Sure.

Jim Mueller: Because you can get paid a heck of a lot for running a covered call on something like PayPal or MongoDB.

Jim Gillies: Yes. If someone-

Jim Mueller: I've done a PayPal covered call in the service.

Jim Gillies: Yes.

Jim Mueller: But, I also set it up.

Jim Gillies: Yes. You'd probably be further ahead if you didn't write the covered call. You just bought the shares and held.

Jim Mueller: Yeah. But I also said, if you want the capital gains, do not rent the covered call or buy extra shares.

Jim Gillies: Yeah. Because there are mitigation strategies you can do out here. If you've written this covered call in Starbucks, Starbucks for whatever reason runs through 140, you can do what's called rolling. You can buy back the previously written $120 strike call, and you could sell say a $130 call expiring in six months to a year, and you're playing games a little bit, but you're also hoping that Starbucks, which has gone on this massive run to 140, it hasn't, Fools, but play along. You're hoping that sanity returns a little bit, and you can catch up. Maybe you can do that. You might get paid a little bit to roll, or maybe you can accomplish it with node costs at a pocket, but you're trying to pick up some of the gains at Starbucks, you're hoping that Starbucks, when the rolling period comes around in six months, or a year, or whatever, you are hoping Starbucks has come down a little bit. As opposed to instead of going down below the new lower strike could say 130, it hasn't run to 200. If it run to 200, you're screwed. But that's what it is.

Ellen Bowman: You're using technical terms today. [laughs]

Jim Mueller: You're not screwed. You're going to sell shares at a 130. You don't get the gains to 200, but you still make money.

Jim Gillies: You still made money.

Jim Mueller: Still made money.

Jim Gillies: The three of us know that that is the goal. But I promise you, the neophyte covered call user, thinks they got screwed.

Jim Mueller: Yeah. I know.

Ellen Bowman: Yeah.

Jim Gillies: The reason I say that is because I've literally been on the receiving end of messages from neophyte covered call users.

Jim Mueller: That's all right.

Jim Gillies: Said, "I got screwed here."

Ellen Bowman: Right. Because I had to sell at 140 or 150, the stock went to 3,000, and now, I don't [inaudible] . [laughs]

Jim Gillies: If Starbucks goes to 3,000, I need to go quiet on fool.com real quick. [laughs]

Ellen Bowman: For a very long time. Yeah, exactly.

Jim Gillies: Just five days, two days, sell it, two days.

Ellen Bowman: [laughs] Never see any of us again?