One of the tools in my investment management toolbox is Options, specifically Covered Call Options and Naked Put Options. I’m reaching out to a number of my clients to recommend that we set up Options. These two Options Strategies work best in volatile markets like what we’ve had in 2022. Options provide better risk management while allowing us to create an additional income stream within your IRA Account.
Sell a Naked Put If…
Let’s say you want to buy 100 shares of SPY and its trading today at $380. Instead of buying the SPY ETF at $380 per share, you could sell to open 1put contract with a strike price of $280 and receive a credit (income) in the amount of $850 in our example. If the SPY is $381 on the expiration date (let’s say in 20 days…) you get to keep the $850.
On the other hand, if SPY is trading at $279 on the expiration day, you will be the proud owner of 100 shares of SPY and you will be obliged to buy 100 shares for $380 per share (but remember you got paid $850 so your $100 loss is actually a $750 gain…)
Margin and Options
This post is specifially for Tax Qualified accounts. We can use additional strategies in Non-Tax Qualified accounts with Margin. Each strategy has its own set of Risk Metrics. In this post, I’ve grabbed some helpful content from Investopedia, my favorite source for Investor Education.
What are Options
Options are a form of contract that gives buyers of the contracts (the option holders) the right (but not the obligation) to buy or sell a security at a chosen price at some point in the future. Option buyers are charged an amount called a by the sellers for such a right. Should market prices be unfavorable for option holders, they will let the option expire worthless and not exercise this right, ensuring that potential losses are not higher than the premium. On the other hand, if the market moves in the direction that makes this right more valuable, it makes use of it.
Options are generally divided into “call” and “put” contracts. With a , the buyer of the contract purchases the right to buy the in the future at a predetermined price, called or . With a , the buyer acquires the right to sell the underlying asset in the future at the predetermined price.
Let’s take a look at some basic strategies that a beginner investor can use with calls or puts to limit their risk. The first two involve using options to place a direction bet with a limited downside if the bet goes wrong. The others involve hedging strategies laid on top of existing positions.
Article on Trading Options –
The following is from Investopedia, my favorite resource for anything about investing.
Key Takeaways
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Options trading may sound risky or complex for beginner investors, and so they often stay away.
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Some basic strategies using options, however, can help a novice investor protect their downside and hedge market risk.
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Here we look at four such strategies: long calls, long puts, covered calls, and protective puts.
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Buying Calls (Long Calls)
There are some advantages to trading options for those looking to make a directional bet in the market. If you think the price of an asset will rise, you can buy a call option using less capital than the asset itself. At the same time, if the price instead falls, your losses are limited to the premium paid for the options and no more. This could be a preferred strategy for traders who:
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Are “bullish” or confident about a particular stock, exchange-traded fund (ETF), or index fund and want to limit risk
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Want to utilize to take advantage of rising prices
Options are essentially leveraged instruments in that they allow traders to amplify the potential upside benefit by using smaller amounts than would otherwise be required if trading the underlying asset itself. So, instead of laying out $10,000 to buy 100 shares of a $100 stock, you could hypothetically spend, say, $2,000 on a call contract with a strike price 10% higher than the current market price.
A standard equity option contract on a stock 100 shares of the .
Example
Suppose a trader wants to invest $5,000 in Apple (), trading at around $165 per share. With this amount, they can purchase 30 shares for $4,950. Suppose then that the price of the stock increases by 10% to $181.50 over the next month. Ignoring any brokerage commission or transaction fees, the trader’s portfolio will rise to $5,445, leaving the trader with a net dollar return of $495, or 10% on the capital invested.
Now, let’s say a call option on the stock with a strike price of $165 that expires about a month from now costs $5.50 per share or $550 per contract. Given the trader’s available investment budget, they can buy nine options for a cost of $4,950. Because the option contract controls 100 shares, the trader is effectively making a deal on 900 shares. If the stock price increases 10% to $181.50 at expiration, the option will expire and be worth $16.50 per share (for a $181.50 to $165 strike), or $14,850 on 900 shares. That’s a net dollar return of $9,990, or 200% on the capital invested, a much larger return compared to trading the underlying asset directly.
Risk/reward
The trader’s potential loss from a long call is limited to the premium paid. Potential profit is unlimited because the option payoff will increase along with the underlying asset price until expiration, and there is theoretically no limit to how high it can go.
Buying Puts (Long Puts)
If a call option gives the holder the right to purchase the underlying at a set price before the contract expires, a put option gives the holder the right to sell the underlying at a set price. This is a preferred strategy for traders who:
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Are bearish on a particular stock, ETF, or index, but want to take on less risk than with a strategy
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Want to utilize leverage to take advantage of falling prices
A put option works effectively in the exact opposite direction from the way a call option does, with the put option gaining value as the price of the underlying decreases. Though short-selling also allows a trader to profit from falling prices, the risk with a short position is unlimited because there is theoretically no limit to how high a price can rise. With a put option, if the underlying ends up higher than the option’s strike price, the option will simply expire worthless.
Risk/reward
The potential loss on a long put is limited to the premium paid for the options. The maximum profit from the position is capped because the underlying price cannot drop below zero, but as with a long call option, the put option leverages the trader’s return.
Covered Calls
Unlike the long call or long put, a is a strategy that is overlaid onto an existing long position in the underlying asset. It is essentially an upside call that is sold in an amount that would cover that existing position size. In this way, the covered call writer collects the option premium as income, but also limits the upside potential of the underlying position. This is a preferred position for traders who:
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Expect no change or a slight increase in the underlying’s price, collecting the full option premium
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Are willing to limit upside potential in exchange for some
A covered call strategy involves buying 100 shares of the underlying asset and selling a call option against those shares. When the trader sells the call, the option’s premium is collected, thus lowering the on the shares and providing some downside protection. In return, by selling the option, the trader is agreeing to sell shares of the underlying at the option’s strike price, thereby capping the trader’s upside potential.
Example
Suppose a trader buys 1,000 shares of BP () at $44 per share and simultaneously writes 10 call options (one contract for every 100 shares) with a strike price of $46 expiring in one month, at a cost of $0.25 per share, or $25 per contract and $250 total for the 10 contracts. The $0.25 premium reduces the cost basis on the shares to $43.75, so any drop in the underlying down to this point will be offset by the premium received from the option position, thus offering limited downside protection.
If the share price rises above $46 before expiration, the short call option will be exercised (or “called away”), meaning the trader will have to deliver the stock at the option’s strike price. In this case, the trader will make a profit of $2.25 per share ($46 strike price – $43.75 cost basis).
However, this example implies the trader does not expect BP to move above $46 or significantly below $44 over the next month. As long as the shares do not rise above $46 and get called away before the options expire, the trader will keep the premium free and clear and can continue selling calls against the shares if desired.
Risk/reward
If the share price rises above the strike price before expiration, the short call option can be exercised and the trader will have to deliver shares of the underlying at the option’s strike price, even if it is below the market price. In exchange for this risk, a covered call strategy provides limited downside protection in the form of the premium received when selling the call option.
Protective Puts
A involves buying a downside put in an amount to cover an existing position in the underlying asset. In effect, this strategy puts a lower floor below which you cannot lose more. Of course, you will have to pay for the option’s premium. In this way, it acts as a sort of insurance policy against losses. This is a preferred strategy for traders who own the underlying asset and want downside protection
Thus, a protective put is a long put, like the strategy we discussed above; however, the goal, as the name implies, is downside protection versus attempting to profit from a downside move. If a trader owns shares with a bullish sentiment in the long run but wants to protect against a decline in the short run, they may purchase a protective put.
If the price of the underlying increases and is above the put’s strike price at , the option expires worthless and the trader loses the premium but still has the benefit of the increased underlying price. On the other hand, if the underlying price decreases, the trader’s portfolio position loses value, but this loss is largely covered by the gain from the put option position. Hence, the position can effectively be thought of as an insurance strategy.
Example
The trader can set the strike price below the current price to reduce premium payment at the expense of decreasing downside protection. This can be thought of as deductible insurance. Suppose, for example, that an investor buys 1,000 shares of Coca-Cola () at a price of $44 and wants to protect the investment from adverse price movements over the next two months. The following put options are available:
| Protective Put Examples | |
|---|---|
| June 2018 options | Premium |
| $44 put | $1.23 |
| $42 put | $0.47 |
| $40 put | $0.20 |
The table shows that the cost of protection increases with the level thereof. For example, if the trader wants to protect the investment against any drop in price, they can buy 10 put options at a strike price of $44 for $1.23 per share, or $123 per contract, for a total cost of $1,230. However, if the trader is willing to tolerate some level of downside risk, choosing a less costly option such as the $40 put could also work. In this case, the cost of the option position will be much lower at only $200.
Risk/reward
If the price of the underlying stays the same or rises, the potential loss will be limited to the option premium, which is paid as insurance. If, however, the price of the underlying drops, the loss in capital will be offset by an increase in the option’s price and is limited to the difference between the initial stock price and strike price plus the premium paid for the option. In the example above, at the strike price of $40, the loss is limited to $4.20 per share ($44 – $40 + $0.20).
Some Other Options Strategies
The four strategies outlined here are straightforward and can be employed by most novice traders or investors. There are, however, more complex and nuanced strategies than simply buying calls or puts. While we discuss these types of strategies elsewhere, here is just a brief list of some other basic options positions that would be suitable for those comfortable with the ones discussed above:
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Married put strategy: Similar to a protective put, the involves buying an put option in an amount to cover an existing long position in the stock. In this way, it mimics a call option (sometimes called a ).
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Protective collar strategy: With a collar, an investor who holds a long position in the underlying buys an out-of-the-money (i.e., downside) put option, while at the same time writing an out-of-the-money (upside) call option for the same stock.
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Long straddle strategy: Buying a lets you capitalize on future volatility but without having to take a bet whether the move will be to the upside or downside—either direction will profit. Here, an investor buys both a call option and a put option at the same strike price and expiration on the same underlying. Because it involves purchasing two at-the-money options, it is more expensive than some other strategies.
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Long strangle strategy: Similar to the straddle, the buyer of a goes long on an out-of-the-money call option and a put option at the same time. They will have the same expiration date, but they have different strike prices: The put strike price should be below the call strike price. This involves a lower outlay of premium than a straddle but also requires the stock to move either higher to the upside or lower to the downside in order to be profitable.
What Are the Levels of Options Trading?
Most brokers assign different levels of options trading approval based on the riskiness involved and complexity involved. The four strategies discussed here would all fall under the most basic levels, level 1 and Level 2. Customers of brokerages will typically have to be approved for options trading up to a certain level and maintain a .
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Level 1: covered calls and protective puts, when an investor already owns the underlying asset
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Level 2: long calls and puts, which would also include straddles and strangles
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Level 3: , involving buying one or more options and at the same time selling one or more different options of the same underlying
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Level 4: selling (writing) , which here means unhedged, posing the possibility for unlimited losses
How Can I Start Trading Options?
Most online brokers today offer options trading. You will have to typically apply for options trading and be approved. You will also need a margin account. When approved, you can enter orders to trade options much like you would for stocks but by using an to identify which underlying, expiration date, and strike price, and whether it is a call or a put. Then, you can place limit orders or market orders for that option.
When Do Options Trade During the Day?
Equity options (options on stocks) trade during normal stock market hours. This is typically 9:30 a.m. to 4 p.m. EST.
Where Do Options Trade?
Listed options trade on specialized exchanges such as the , the , or the , among others. These exchanges are largely electronic nowadays, and orders you send through your broker will be routed to one of these exchanges for best execution.
Can You Trade Options for Free?
Though many brokers now offer commission-free trading in stocks and ETFs, options trading still involves fees or commissions. There will typically be a fee-per-trade (e.g., $4.95) plus a commission per contract (e.g., $0.50 per contract). Therefore, if you buy 10 options under this pricing structure, the cost to you would be $4.95 + (10 x $0.50) = $9.95.
The Bottom Line
Options offer alternative strategies for investors to profit from trading underlying securities. There’s a variety of strategies involving different combinations of options, underlying assets, and other derivatives. Basic strategies for beginners include buying calls, buying puts, selling covered calls, and buying protective puts. There are advantages to trading options rather than underlying assets, such as downside protection and leveraged returns, but there are also disadvantages like the requirement for upfront premium payment. The first step to trading options is to choose a broker.
Fortunately, Investopedia has created a list of the to make getting started easier.
Options Trading Guide
Options trading may seem overwhelming at first, but it’s easy to understand if you . Investor portfolios are usually constructed with several asset classes. These may be stocks, bonds, ETFs, and even mutual funds.
Options are another asset class, and when used correctly, they offer many advantages that trading stocks and ETFs alone cannot.
Key Takeaways
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An option is a contract giving the buyer the right—but not the obligation—to buy (in the case of a call) or sell (in the case of a put) the underlying asset at a specific price on or before a certain date.
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People use options for income, to speculate, and to hedge risk.
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Options are known as derivatives because they derive their value from an underlying asset.
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A stock option contract typically represents 100 shares of the underlying stock, but options may be written on any sort of underlying asset from bonds to currencies to commodities.
What Are Options?
Options are contracts that give the bearer the right—but not the obligation—to either buy or sell an amount of some underlying asset at a predetermined price at or before the contract expires. Like most other asset classes, options can be purchased with .
Options are powerful because they can enhance an individual’s portfolio. They do this through added income, protection, and even leverage. Depending on the situation, there is usually an option scenario appropriate for an investor’s goal. A popular example would be using options as an effective against a declining stock market to limit downside losses.
Options can also generate recurring income. Additionally, they are often used for speculative purposes, such as wagering on the direction of a stock.
There is no free lunch with stocks and bonds. Options are no different. Options trading involves certain risks that the investor must be aware of before making a trade. This is why, when trading options with a broker, you usually see a disclaimer similar to the following.
Options involve risks and are not suitable for everyone. Options trading can be speculative in nature and carry a substantial risk of loss.
Options Are Derivatives
Options belong to the larger group of securities known as . A derivative’s price is dependent on or derived from the price of something else. Options are derivatives of financial securities—their value depends on the price of some other asset. Examples of derivatives include calls, puts, futures, , , and mortgage-backed securities, among others.
Call and Put Options
Options are a type of derivative security. An option is a derivative because its price is intrinsically linked to the price of something else. If you buy an , it grants you the right but not the obligation to buy or sell an underlying asset at a set price on or before a certain date.
A gives the holder the right to buy a stock and a gives the holder the right to sell a stock. Think of a call option as a down payment on a future purchase.
Call Option Example
A potential homeowner sees a new development going up. That person may want the right to purchase a home in the future but will only want to exercise that right after certain developments around the area are built.
The potential homebuyer would benefit from the option of buying or not. Imagine they can buy a call option from the developer to buy the home at say $400,000 at any point in the next three years. Well, they can—you know it as a non-refundable deposit. Naturally, the developer wouldn’t grant such an option for free. The potential homebuyer needs to contribute a down payment to lock in that right.
With respect to an option, this cost is known as the . It is the price of the option contract. In our home example, the deposit might be $20,000 that the buyer pays the developer. Let’s say two years have passed, and now the developments are built and zoning has been approved. The homebuyer exercises the option and buys the home for $400,000 because that is the contract purchased.
The market value of that home may have doubled to $800,000. But because the down payment locked in a predetermined price, the buyer pays $400,000. Now, in an alternate scenario, say the zoning approval doesn’t come through until year four. This is one year past the expiration of this option. Now the homebuyer must pay the market price because the contract has expired. In either case, the developer keeps the original $20,000 collected.
Put Option Example
Now, think of a put option as an insurance policy. If you own your home, you are likely familiar with the process of purchasing homeowner’s insurance. A homeowner buys a homeowner’s policy to protect their home from damage. They pay an amount called a premium for a certain amount of time, let’s say a year. The policy has a face value and gives the insurance holder protection in the event the home is damaged.
What if, instead of a home, your asset was a stock or index investment? Similarly, if an investor wants insurance on their S&P 500 index portfolio, they can purchase put options. An investor may fear that a bear market is near and may be unwilling to lose more than 10% of their long position in the S&P 500 index. If the S&P 500 is currently trading at $2,500, they can purchase a put option giving them the right to sell the index at $2,250, for example, at any point in the next two years.
If in six months the market crashes by 20% (500 points on the index), they have made 250 points by being able to sell the index at $2,250 when it is trading at $2,000—a combined loss of just 10%. In fact, even if the market drops to zero, the loss would only be 10% if this put option is held. Again, purchasing the option will carry a cost (the premium), and if the market doesn’t drop during that period, the maximum loss on the option is just the premium spent.
Buying & Selling Calls and Puts
There are four things you can do with options:
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Buy (long) calls
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Sell (short) calls
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Buy (long) puts
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Sell (short) puts
Buying stock gives you a long position. Buying a call option gives you a potential long position in the underlying stock. Short-selling a stock gives you a short position. Selling a naked or uncovered call gives you a potential short position in the underlying stock.
Buying a put option gives you a potential short position in the underlying stock. Selling a naked or unmarried put gives you a potential long position in the underlying stock. Keeping these four scenarios straight is crucial.
People who buy options are called holders and those who sell options are called of options. Here is the important distinction between holders and writers:
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Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights. This limits the risk of buyers of options to only the premium spent.
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Call writers and put writers (sellers), however, are obligated to buy or sell if the option expires in the money (more on that below). This means that a seller may be required to make good on a promise to buy or sell. It also implies that option sellers have exposure to more—and in some cases, unlimited—risks. This means writers can lose much more than the price of the options premium.
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Why Use Options
Speculation
Speculation is a wager on future price direction. A speculator might think the price of a stock will go up, perhaps based on fundamental analysis or technical analysis. A speculator might buy the stock or buy a call option on the stock. Speculating with a call option—instead of buying the stock outright—is attractive to some traders because options provide leverage. An out-of-the-money call option may only cost a few dollars or even cents compared to the full price of a $100 stock.
Hedging
Options were really invented for hedging purposes. Hedging with options is meant to reduce risk at a reasonable cost. Here, we can think of using options like an insurance policy. Just as you insure your house or car, options can be used to insure your investments against a downturn.
Imagine that you want to buy technology stocks, but you also want to limit losses. By using put options, you could limit your downside risk and enjoy all the upside in a cost-effective way. For , call options can be used to limit losses if the underlying price moves against their trade—especially during a .
How Options Work
In terms of valuing option contracts, it is essentially all about determining the probabilities of future price events. The more likely something is to occur, the more expensive an option that profits from that event would be. For instance, a call value goes up as the stock (underlying) goes up. This is the key to understanding the relative value of options.
The less time there is until expiry, the less value an option will have. This is because the chances of a price move in the underlying stock diminish as we draw closer to expiry. This is why an option is a wasting asset. If you buy a one-month option that is out of the money, and the stock doesn’t move, the option becomes less valuable with each passing day. Because time is a component of the price of an option, a one-month option is going to be less valuable than a three-month option. This is because with more time available, the probability of a price move in your favor increases, and vice versa.
Accordingly, the same option strike that expires in a year will cost more than the same strike for one month. This wasting feature of options is a result of . The same option will be worth less tomorrow than it is today if the price of the stock doesn’t move.
Volatility also increases the price of an option. This is because uncertainty pushes the odds of an outcome higher. If the volatility of the underlying asset increases, larger price swings increase the possibilities of substantial moves both up and down. Greater price swings will increase the chances of an event occurring. Therefore, the greater the volatility, the greater the price of the option. Options trading and volatility are intrinsically linked to each other in this way.
On most U.S. exchanges, a stock option contract is the option to buy or sell 100 shares; that’s why you must multiply the contract premium by 100 to get the total amount you’ll have to spend to buy the call.
| What happened to our option investment | |||
|---|---|---|---|
| May 1 | May 21 | Expiry Date | |
| Stock Price | $67 | $78 | $62 |
| Option Price | $3.15 | $8.25 | worthless |
| Contract Value | $315 | $825 | $0 |
| Paper Gain/Loss | $0 | $510 | -$315 |
The majority of the time, holders choose to take their profits by trading out (closing out) their position. This means that option holders sell their options in the market, and writers buy their positions back to close. Only about 10% of options are exercised, 60% are traded (closed) out, and 30% expire worthlessly.
Fluctuations in option prices can be explained by and , which is also known as time value. An option’s premium is the combination of its intrinsic value and time value. Intrinsic value is the in-the-money amount of an options contract, which, for a call option, is the amount above the strike price that the stock is trading. Time value represents the added value an investor has to pay for an option above the intrinsic value. This is the extrinsic value or time value. So the price of the option in our example can be thought of as the following:
| Premium = | Intrinsic Value + | Time Value |
|---|---|---|
| $8.25 | $8.00 | $0.25 |
In real life, options almost always trade at some level above their intrinsic value, because the probability of an event occurring is never absolutely zero, even if it is highly unlikely.
Call Options vs. Put Options
Call options and put options can only function as effective hedges when they limit losses and maximize gains. Suppose you’ve purchased 100 shares of Company XYZ’s stock, betting that its price will increase to $20. Therefore, your total investment is $1,000. To hedge against the risk that the price might decline, you purchase one put option (each options contract represents 100 shares of underlying stock) with a strike price of 10, each worth $2 (for a total of $200).
Consider the situation when the stock’s price goes your way (i.e., it increases to $20). In such a scenario, your put options expire worthless. But your losses are limited to the premium paid (in this case, $200). If the price declines (as you bet it would in your put options), then your maximum gains are also capped. This is because the stock price cannot fall below zero, and therefore, you cannot make more money than the amount you make after the stock’s price falls to zero.
Now, consider a situation in which you’ve bet that XYZ’s stock price will decline to $5. To hedge against this position, you’ve purchased call stock options, betting that the stock’s price will increase to $20. What happens if the stock’s price goes your way (i.e., it declines to $5)? Your call options will expire worthless and you will have losses worth $200. There are no upper limits on XYZ’s price after it takes off. Theoretically, XYZ can go all the way to $100,000 or higher. Therefore, your gains are not capped and are unlimited.
The table below summarizes gains and losses for options buyers.
| Maximum Gain | Maximum Loss | |
|---|---|---|
| Call Buyer | Unlimited | Premium |
| Put Buyer | Limited | Premium |
Uses of Call and Put Options
Call options and put options are used in a variety of situations. The table below outlines some use cases for call and put options.
| Call Options | Put Options |
|---|---|
| Buyers of call options use them to hedge against their position of a declining price for the security or commodity. | Buyers of put options use them to hedge against their position of a rising price for the security or commodity. |
| American importers can use call options on the U.S. dollar to hedge against a decline in their purchasing power. | American exporters can use put options on the U.S. dollar to hedge against a rise in their selling costs. |
| Holders of American depository receipts (ADRs) in foreign companies can use call options on the U.S. dollar to hedge against a decline in dividend payments. | Manufacturers in foreign countries can use put options on the U.S. dollar to hedge against a decline in their native currency for payment. |
| Short sellers use call options to hedge against their positions. | Short sellers have limited gains from put options because a stock’s price can never fall below zero. |
How Do Experienced Investors Use Options?
As mentioned earlier, traders use options to speculate and hedge. To maximize their returns, traders track options prices and employ sophisticated strategies, such as a strangle or an iron condor. Here is a quick introduction to some of the strategies that are fairly simple but effective in making money. You can find out more about options strategies here.
Long Calls
As the name indicates, going long on a call involves buying call options, betting that the price of the underlying asset will increase with time. For example, suppose a trader purchases a contract with 100 call options for a stock that’s currently trading at $10. Each option is priced at $2. Therefore, the total investment in the contract is $200. The trader will recoup her costs when the stock’s price reaches $12.
Thereafter, the stock’s gains are profits for her. There are no upper bounds on the stock’s price, and it can go all the way up to $100,000 or even further. A $1 increase in the stock’s price doubles the trader’s profits because each option is worth $2. Therefore, a long call promises unlimited gains. If the stock goes in the opposite price direction (i.e., its price goes down instead of up), then the options expire worthless and the trader loses only $200. Long calls are useful strategies for investors when they are reasonably certain a given stock’s price will increase.
Covered Call
In a short call, the trader is on the opposite side of the trade (i.e., they sell a call option as opposed to buying one), betting that the price of a stock will decrease in a certain time frame. Because it is a naked call, a short call can have unlimited gains because if the price goes the trader’s way, then they could rake in money from call buyers.
But writing a call without owning actual stock can also mean significant losses for the trader because, if the price doesn’t go in the planned direction, then they would have to spend a considerable sum to purchase and deliver the stock at inflated prices.
A covered call limits their losses. In a covered call, the trader already owns the underlying asset. Therefore, they don’t need to purchase the asset if its price goes in the opposite direction. Thus, a covered call limits losses and gains because the maximum profit is limited to the amount of premiums collected. Covered calls writers can buy back the options when they are close to in the money. Experienced traders use covered calls to generate income from their stock holdings and balance out tax gains made from other trades.
Long Put
A long put is similar to a long call except that the trader will buy puts, betting that the underlying stock’s price will decrease. Suppose a trader purchases a one 10-strike put option (representing the right to sell 100 shares at $10) for a stock trading at $20. Each option is priced at a premium of $2. Therefore, the total investment in the contract is $200. The trader will recoup those costs when the stock’s price falls to $8 ($10 strike – $2 premium).
Thereafter, the stock’s losses mean profits for the trader. But these profits are capped because the stock’s price cannot fall below zero. The losses are also capped because the trader can let the options expire worthless if prices move in the opposite direction. Therefore, the maximum losses that the trader will experience are limited to the premium amounts paid. Long puts are useful for investors when they are reasonably certain that a stock’s price will move in their desired direction.
Short Put
In a short put, the trader will write an option betting on a price increase and sell it to buyers. In this case, the maximum gains for a trader are limited to the premium amount collected. However, the maximum losses can be unlimited because she will have to buy the underlying asset to fulfill her obligations if buyers decide to exercise their option.
Despite the prospect of unlimited losses, a short put can be a useful strategy if the trader is reasonably certain that the price will increase. The trader can buy back the option when its price is close to being in the money and generates income through the premium collected.
Types of Options
American and European options
can be exercised at any time between the date of purchase and the expiration date.1 are different from American options in that they can only be exercised at the end of their lives on their expiration date.2
The distinction between has nothing to do with geography, only with early exercise. Many options on stock indexes are of the European type. Because the right to exercise early has some value, an American option typically carries a higher premium than an otherwise identical European option. This is because the early exercise feature is desirable and commands a premium.
There are also , which are exotic because there might be a variation on the payoff profiles from the plain vanilla options. Or they can become totally different products all together with “optionality” embedded in them. For example, have a simple payoff structure that is determined if the payoff event happens regardless of the degree.
Other types of exotic options include knock-out, knock-in, barrier options, lookback options, , and . Again, exotic options are typically for professional derivatives traders.
Short-Term Options Vs. Long-Term Options
Options can also be categorized by their duration. Short-term options are those that generally expire within a year. Long-term options with expirations greater than a year are classified as , or LEAPs. LEAPs are identical to regular options except that they have longer durations.
| Short-Term Options | Long-Term Options | LEAPs |
|---|---|---|
| Time value and extrinsic value of short-term options decay rapidly due to their short durations. | Time value does not decay as rapidly for long-term options because they have a longer duration. | Time value decay is minimal for a relatively long period because the expiration date is a long time away. |
| The main risk component in holding short-term options is the short duration. | The main component of holding long-term options is the use of leverage, which can magnify losses, to conduct the trade. | The main component of risk in holding LEAPs is an inaccurate assessment of a stock’s future value. |
| They are fairly cheap to purchase. | They are more expensive compared to short-term options. | They are generally underpriced because it is difficult to estimate the performance of a stock far out in the future. |
| They are generally used during catalyst events for the underlying stock’s price, such as an earnings announcement or a major news development. | They are generally used as a proxy to holding shares in a company and with an eye toward an expiration date. | LEAPs expire in January and investors purchase them to hedge long-term positions in a given security. |
| They can be American- or European-style options. | They can be American- or European-style options. | They are American-style options only. |
| They are taxed at a short-term capital gains rate. | They are taxed at a long-term capital gains rate. | They are taxed at a long-term capital gains rate. |
You can read a more detailed discussion of options and taxes .
Options can also be distinguished by when their expiration date falls. Sets of options now expire weekly on each Friday, at the end of the month, or even on a daily basis. Index and ETF options also sometimes offer quarterly expiries.
Reading Options Tables
More and more traders are finding option data through online sources. Though each source has its own format for presenting the data, the key components generally include the following variables:
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Volume (VLM) simply tells you how many contracts of a particular option were traded during the latest session.
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The “bid” price is the latest price level at which a market participant wishes to buy a particular option.
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The “ask” price is the latest price offered by a market participant to sell a particular option.
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Implied Bid Volatility (IMPL BID VOL) can be thought of as the future uncertainty of price direction and speed. This value is calculated by an option-pricing model such as the Black-Scholes model and represents the level of expected future volatility based on the current price of the option.
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An Open Interest (OPTN OP) number indicates the total number of contracts of a particular option that have been opened. Open interest decreases as open trades are closed.
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Delta can be thought of as a probability. For instance, a 30-delta option has roughly a 30% chance of expiring in the money. Delta also measures the option’s sensitivity to immediate price changes in the underlying. The price of a 30-delta option will change by 30 cents if the underlying security changes its price by $1.
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Gamma is the speed the option for moving in or out of the money. Gamma can also be thought of as the movement of the delta.
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Vega is a Greek value that indicates the amount by which the price of the option would be expected to change based on a one-point change in implied volatility.
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Theta is the Greek value that indicates how much value an option will lose with the passage of one day’s time.
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The “strike price” is the price at which the buyer of the option can buy or sell the underlying security if they choose to exercise the option.
Buying at the bid and selling at the ask is how market makers make their living.
Long Calls and Puts
The simplest options position is a long call (or put) by itself. This position profits if the price of the underlying rises (falls), and your downside is limited to the loss of the option premium spent. If you simultaneously buy a call and put option with the same strike and expiration, you’ve created a straddle.
This position pays off if the underlying price rises or falls dramatically; however, if the price remains relatively stable, you lose premium on both the call and the put. You would enter this strategy if you expect a large move in the stock but are not sure in which direction.
Basically, you need the stock to have a move outside of a range. A similar strategy betting on an outsized move in the securities when you expect high volatility (uncertainty) is to buy a call and buy a put with different strikes and the same expiration—known as a strangle. A strangle requires larger price moves in either direction to profit but is also less expensive than a straddle.
On the other hand, being short either a straddle or a strangle (selling both options) would profit from a market that doesn’t move much.
Spreads and Combinations
Spreads use two or more options positions of the same class. They combine having a market opinion (speculation) with limiting losses (hedging). Spreads often limit potential upside as well. Yet these strategies can still be desirable since they usually cost less when compared to a single options leg. Vertical spreads involve selling one option to buy another. Generally, the second option is the same type and same expiration but a different strike.
A bull call spread, or bull call vertical spread, is created by buying a call and simultaneously selling another call with a higher strike price and the same expiration. The spread is profitable if the underlying asset increases in price, but the upside is limited due to the short call strike. The benefit, however, is that selling the higher strike call reduces the cost of buying the lower one.
Similarly, a bear put spread, or bear put vertical spread, involves buying a put and selling a second put with a lower strike and the same expiration. If you buy and sell options with different expirations, it is known as a calendar spread or time spread.
Combinations are trades constructed with both a call and a put. There is a special type of combination known as a “synthetic.” The point of a synthetic is to create an options position that behaves like an underlying asset but without actually controlling the asset. Why not just buy the stock? Maybe some legal or regulatory reason restricts you from owning it. But you may be allowed to create a synthetic position using options.
Butterflies
A butterfly consists of options at three strikes, equally spaced apart, wherein all options are of the same type (either all calls or all puts) and have the same expiration. In a long butterfly, the middle strike option is sold and the outside strikes are bought in a ratio of 1:2:1 (buy one, sell two, buy one).
If this ratio does not hold, it is not a butterfly. The outside strikes are commonly referred to as the wings of the butterfly, and the inside strike as the body. The value of a butterfly can never fall below zero. Closely related to the butterfly is the condor—the difference is that the middle options are not at the same strike price.
Options Risks: The “Greeks”
Because options prices can be modeled mathematically with a model such as the Black-Scholes model, many of the risks associated with options can also be modeled and understood. This particular feature of options actually makes them arguably less risky than other asset classes, or at least allows the risks associated with options to be understood and evaluated. Individual risks have been assigned Greek letter names, and are sometimes referred to simply as “the Greeks.”
What Does Exercising an Option Mean?
Exercising an option means executing the contract and buying or selling the underlying asset at the stated price.
Why Do Traders Use Options?
Traders generally use options to speculate and hedge. For example, a trader might hedge an existing bet made on the price increase of an underlying security by purchasing put options.
What Is the Difference Between American Options and European Options?
American options can be exercised anytime before expiration, but European options can be exercised only at the stated expiry date.
How Is Risk Measured With Options?
The risk content of options is measured using four different dimensions known as “the Greeks.” These include the , , , and .
What Are the Three Important Characteristics of Options?
The three important characteristics of options are as follows:
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Strike price: This is the price at which an option can be exercised.
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Expiration date: This is the date at which an option expires and becomes worthless.
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Option premium: This is the price at which an option is purchased.
4 Ways to Trade Options
Long/short calls and long/short puts
Updated March 03, 2022
While there are many exotic-sounding variations, there are ultimately only four basic positions to trade in the options market: You can either buy or sell call options, or buy or sell put options. In establishing a new position, options traders can either buy or sell to open. Existing positions are canceled by either selling or buying to close.
Regardless of which side of the trade you take, you’re making a bet on the price direction of the underlying asset. But the buyer and seller of options stand to profit in very different ways.
Key Takeaways
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There are four basic options positions: buying a call option, selling a call option, buying a put option, and selling a put option.
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With call options, the buyer is betting that the market price of an underlying asset will exceed a predetermined price, called the strike price, while the seller is betting it won’t.
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With put options, the option buyer is betting the market price of an underlying asset will fall below the strike price, while the seller is betting it won’t.
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Buyers of call or put options are limited in their losses to the cost of the option (it’s premium). Unhedged sellers of options face theoretically unlimited losses.
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Spreads with options involve simultaneously buying and selling different options contracts on the same underlying.
What Do The Phrases “Sell To Open,” “Buy To Close,” “Buy To Open,” And “Sell To Close” Mean?
Trading Call Options
A gives the buyer, or holder, the right to buy the underlying asset—such as a stock, currency, or commodity —at a predetermined price . As the name “option” implies, the holder has the right to buy the asset at the agreed price—called the —but not the obligation.
Every option is essentially a contract, or bet, between two parties. In the case of call options, the buyer is betting that the price of the underlying asset will be higher on the open market than the strike price—and that it will exceed the strike price before the option expires. If so, the option buyer can buy that asset from the option seller at the strike price and then resell it for a profit.
The buyer of a call option must pay an upfront fee for the right to make that deal. The fee, called a premium, is paid at the outset to the seller, who is betting the asset’s market price won’t be higher than the price specified in the option. In most basic options, that premium is the profit the seller seeks. It is also the risk exposure, or maximum loss, of the option buyer. The premium is based on a percentage of the size of the possible trade.
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Trading Put Options
A , on the other hand, gives the buyer the right to sell an underlying asset at a specified price on or before a certain date. In this case, the buyer of the put option is essentially shorting the underlying asset, betting that its market price will fall below the strike price in the option. If so, they can buy the asset at the lower market price and then sell it to the option seller, who is obligated to buy it at the higher, agreed strike price.
Again, the put seller, or writer, is taking the other side of the trade, betting the market price won’t fall below the price specified in the option. For making this bet, the put seller receives a premium from the option buyer.
Call and put options have a risk metric known as the . The delta tells you how much the option’s price will tend to change given a $1 move in the underlying security.
To Open vs. to Close
There are additional terms to know when executing these four basic trades. The phrase “” refers to a trader buying either a put or call option that establishes a new position. Buying to open increases the in a particular option, and increasing open interest can signal greater liquidity and point to market expectations. “” is when the holder of the options (i.e., the original buyer of the option) closes out their call or put position by selling it for either a net profit or loss. Note that options positions will always expire on the expiration date for a particular contract. At that point, options will be exercised and options will expire worthless. There is no need to sell to close if an options position is held to expiration.
A trader may also “,” establishing a new position that is short either a call or a put. A short put is actually taking a long position in the underlying market because put options rise in value as the underlying price declines. When you sell an option “” (i.e., unhedged), the option seller (known sometimes as the ) is exposed, in theory, to unlimited risk. This is because the seller of an option receives the premium at the time of the trade, but if a short call position sees a rapidly rising underlying market, they can quickly see losses mount. “” means the option writer is closing out the put or call option they sold.
Other Options Terminology
In addition to these four basic options positions, traders can also use options to build spreads or combinations. A spread involves buying and selling options together on the same underlying, while a combination is buying (selling) two or more options. Here are a few basics:
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: Buy (sell) one call (put) and sell (buy) and more out-of-the-money call (put). Vertical spreads that profit in up markets are ; in down markets .
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: Buy (sell) an option with one maturity to sell (buy) an option with a different maturity.
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: buying both a call and a put of the same strike and expiration
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: buying both a call and a put at the same expiration but different (out-of-the-money) strikes.
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: a market-neutral strategy involving buying (selling) a straddle and selling (buying) a strangle
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: sell shares against an existing stock position.
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: buy shares against an existing stock position.
Trading Options for Beginners
Options are more complex than basic stocks trading and require . Therefore, basic options strategies may be appropriate for certain beginners but only after all risks are understood as well as how options work. In general, options used to hedge existing positions or for taking long positions in puts or calls are the most appropriate for less-experienced traders.
The Difference Between a Call Option and a Put Option
A call option gives the holder the right (but not the obligation) to buy the underlying asset at a specified price at or before its expiration. A put contract instead grants the right to sell it.
Can I Lose Money Buying a Call?
If you buy a call, the breakeven price will be the strike price of the call plus the (i.e., the price) paid for it. So, if a $25-strike call is trading at $2.00 when the share price is at $20, the stock would have to rise above $27.00 before it expires to break even. If not, the trader will lose up to a maximum of the $2.00 paid for the contract.
How Are Options Taxed?
Call and put options are generally taxed based on their holding duration. They incur capital gains taxes. Beyond that, the specifics of taxed options depend on their holding period and whether they are naked or covered.
The Bottom Line
Options do not have to be difficult to understand when you grasp their
