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DIY Guide to Options Trading: Options, Puts, and Calls Explained

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October 25, 2016
Interlocking blocks: Options basics: defining puts and calls for both buyers and sellers.

Options give traders, well, options. But options aren’t just for traders; they can give investors options, too. Investors use them to reduce risk and potentially increase returns. Options are not suitable for everyone, however, as  they involve significant risks. 

Options allow you to trade in different market conditions by letting you speculate on the direction of the market, hedge against market downturns, or create portfolio income. This is why many active traders and passive investors add them to their arsenals. In this series of “Do It Yourself” articles, we’ll define options, what it takes to buy options, and how to sell them.

First, the basics. There are two types of options: calls and puts. Each has its benefits and risks, and these change depending on if you’re the option buyer or the option seller. Let’s start with calls.

Call Up: Buyers

In other words, suppose a trader is interested in a stock but isn't sure if she wants to buy it today because of the high price of the stock in the open market. Instead of buying the shares, she buys a call option that gives her the right to buy the shares on or before a later day (expiration day), at a specified price (strike price). This gives her the potential to profit (or lose)  if the stock makes a move. And it gives her more time to decide whether or not she wants to spend the money on the shares. The cost of the option is the premium. 

Buying a call option is kind of like buying a coupon for a dinner at half the price from one of those group coupon sites. For example, suppose you pay $25 for a coupon that entitles you to a $50 Kobe beef steak dinner. However, suppose new trade restrictions and tariffs on Japanese beef have recently caused the regular price of the dinner to rise to $55. Suddenly, the coupon is worth more than you paid for it because, although you are still entitled to the same steak dinner, its value has risen by five dollars, from $50 to $55.  So now you may have a choice. Suppose your brother-in-law is interested in using the coupon for date night, and has offered you $30 for your coupon. Do you keep it or sell it? Will you have an opportunity to redeem it on your own? Remember, you must use the coupon before its expiration date, or else it will expire worthless and you will have lost the $25 you paid for it.

Now, let's imagine that there was a huge influx of Kobe beef to the U.S. The high supply of beef caused steak dinner prices to tumble, and the restaurant is now offering the same steak dinner for $20. Your coupon is now worthless, because the price of the dinner in the open market is lower than the price you paid for the coupon.

Like the coupon, the option derives its value from the underlying instrument. That’s why another name for options is derivatives.

Our coupon example illustrates that buying a call is a bullish strategy because it can profit if the underlying product rises in value. If you’re bullish on a stock, you could choose to buy a call. However, a call option depreciates in value as time passes. Almost every day, your option shrinks by a few cents until it expires. At that point the option will be worth the difference between the stock price and the option’s buy price. Your option may have some value, or it may be worthless.

Call Up: Seller

Now, what if you decide to sell a call? Let’s start by rephrasing the definition of a call option. 

As a call seller, you're bearish or at least neutral on the underlying stock because you’re taking the other side of the bullish call buyer.

However, depending on the call option you sell, you don’t have to be super bearish. In fact, you can be relatively neutral. Do you remember how we said that options depreciate? Well, as a call seller, the depreciation works to your benefit. If you sold a call that obligates you to sell shares of the stock at $50, as long as the stock price stays below $50, you likely won’t have to sell your shares. This agreed-upon price is the strike price—that’s price at which you “struck” a deal. However there is a chance you could be assigned at any time, even if stock price is below the strike price.

When you sell a call option, you receive a credit. This credit is for you to keep no matter what happens. However, this doesn't mean you'll profit no matter what happens. If the stock rallies above the strike price,you're obligated to sell the shares at the lower (strike) price. If you don't possess the shares you'll have to buy them at the higher (current market) price. And, theoretically a stock price could climb forever. If you do have the shares in your account then you just missed out any price movement above the strike price. You do have the ability to buy back the option. So, if the price does start rise, you could close the contract. This may result in a a smaller profit than the credit or a loss. 

So remember, if you’re bullish, you could buy a call. If you’re bearish or neutral, you could sell a call. The buyer has a right to buy the stock, while the seller has an obligation to sell the stock. Finally, remember that options depreciate in value as time passes, which benefits the seller but hurts the buyer.

Put Down

Imagine a trader is considering selling a stock or simply thinks a stock’s price is going to fall. So, he buys a put that locks in a sale price. A put allows him to sell his stock at a set price, the strike price, so that if the stock price falls, he can exercise the put contract. For investors who don’t own stock, a put is a bear-market vehicle that allows them to speculate on whether or not a stock will fall. No matter which strategy you use, the put increases in value as the underlying stock price falls. But, remember, as time passes, options depreciate in value.

When you sell a put, you’re taking the other side of the put buyer’s bearish trade, which makes your side of the trade bullish. Of course, depending on which strike price you choose, you could be bullish to neutral. You simply want the stock price to stay above the strike price and the option value to decline under time decay, making your trade profitable. 

If the underlying stock price falls below the strike price, you will likely be required to buy the shares of stock. This could require a substantial amount of money. However, this isn’t all bad. If it’s a stock you’d like to own, then selling puts can be one way to buy it at a lower price than the current market while making a little bit of income. But of course, you have to make sure have sufficient funds in your account to purchase the shares. And keep in mind that the stock price could continue to fall, resulting in a loss.

Remember: in general, buy calls or sell puts when bullish and buy puts or sell calls when bearish.


CALLPUT
LONG
* Buyer of options contract
* Has the right to exercise contract
LONG CALL
* Buying the right to buy the underlying at the strike price
* Bullish
LONG PUT
* Buying the right to sell the underlying at the strike price
* Bearish
SHORT
* Seller of options contract
* Obligated to fulfill contract if exercised
SHORT CALL
* Obligated to sell the underlying at the strike price
* Bearish
SHORT PUT
* Obligated to buy the underlying at the strike price
* Bullish
TABLE 1: OPTION USE MATRIX. Courtesy of the Investools® from TD Ameritrade Holding Corporation Income Investing “Options Strategy” course. 

Conclusion

You’ve learned the basic concepts of options, including definitions for calls and puts. You saw some of the benefits and risks to buying options versus selling options. And you learned when you can apply options. However, we’ve only scratched the surface. In the next article we’ll look deeper into the process of buying options and what you need to know.

Are you ready to become an options guru? Check out the Options Strategies course from Investools® from TD Ameritrade Holding Corp.  It’ll help you understand options, and even provides sample option strategies. 

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