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Know Your Options: The Basics of Calls and Puts

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February 28, 2017
Know Your Options: The Basics of Calls and Puts
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One of the main things that makes options attractive to some investors is the flexibility they can provide during a variety of market conditions. Regardless of whether the market is going up, down, or sideways there are options strategies that can be used to speculate on the direction of different investments, generate income, and potentially hedge against market declines. Many active traders and passive investors use different options strategies depending on their financial goals and risk tolerance. Of course, options trading involves significant risks and is not suitable for everyone. So be sure to educate yourself on how they work before diving in.

If you’ve always wanted to learn more about options, be sure to check out the TD Ameritrade 2017 Boston Market Drive, which is a free, live event. On March 11, TD Ameritrade's Chief Market Strategist JJ Kinahan and others will cover everything from the basics to more advanced options strategies, technical analysis, probabilities trading, and more.

Calls and Puts

Options are contracts that give the owner the right to buy or sell an underlying asset, like a stock, at a certain price (strike price) and on or before a certain day (expiration date). It’s important to know that one options contract is the option to buy or sell 100 shares of the underlying asset. There are two types of options, calls and puts:

  1. A call option is a contract that gives the owner the right to buy an underlying asset at a specific price (the “strike” price) on or before the expiration date. On the other hand, the seller (writer) of a call receives income (premium) in exchange for the obligation to sell the underlying asset at the strike price on or before the expiration date.
  2. A put option is a contract that gives the owner the right to sell an underlying asset at the strike price on or before the expiration date. The seller of a put receives income (premium) in exchange for the obligation to buy the underlying asset at the strike price  on or before the expiration date.

Table 1 below shows the basic differences between calls and puts and if they’re generally a bullish or bearish strategy depending on whether you are an owner or a seller. But calls and puts are just the beginning. Different combinations of calls and puts can be used to execute more advanced options techniques like Butterflies and Iron Condors. Different options strategies could be used to pursue a variety of different financial goals. 

Options use matrix: long call, long put, short call, short put

TABLE 1: OPTION USE MATRIX.

Courtesy of the Investools® from TD Ameritrade Holding Corporation Income Investing “Options Strategy” course. Investools, Inc. and TD Ameritrade, Inc. are separate but affiliated firms and are not responsible for each others services or policies.

 

Know The Multiplier

When looking at prices on an options chain, it’s important to note that the bids and asks are a fraction of the actual dollar amount paid or received when opening or exiting positions. That’s where the multiplier comes in. The multiplier for a standard options contract is 100. For standard equities, exchange-traded funds (ETF), and index contracts, the actual dollar amount that changes hands is equal to the current bids and offers multiplied by 100.

A multiplier is simply the numerical value used to compute the total premium paid or received for an options contract. Because each options contract controls 100 shares of stock, using the options multiplier allows you to compute the actual cash value of the options contracts. That’s essential to help you get your head around just how much skin you have in the game. Always think in terms of the multiplier when determining correct position sizes as you add or remove options positions from your portfolio.

Puts and Calls in Practice

Options are often attractive because there are a lot of ways they can be used depending on your financial goals and market conditions. But that doesn’t mean they’re easy to profit from. Here are some common examples of how puts and calls are used:

  1. Long calls are a bullish option strategy that, in a way, is an extension of buy and hold investing. Unlike buying and holding a stock, with options you need to select the strike price and the expiration date. For example, let’s say XYZ stock is trading around $20. You’re very bullish on XYZ so you buy 1 XYZ Call with a strike price of $25 expiration in January 2018, and the option premium for the contract is $5. Your maximum loss is the amount you pay for the contract, $500 ($5 option premium x option multiplier of 100) and your maximum gain is unlimited since there is no cap on how much the stock price could increase. The breakeven point is $30 ($25 strike price + $5 option premium paid), so you are hoping that XYZ’s stock price rises above $30 before or on expiration.
  2. Long puts are a bearish option strategy. For example, let’s say XYZ is trading around $20, but you think the company’s sales are going to decline and the stock  will go to $10. You buy 1 XYZ put with a strike price of $20, expiration in January 2018, and the option premium is $2. Your maximum loss is $200 ($2 option premium x option multiplier of 100) and your maximum gain is $1800 ($20 strike price - $2 option premium x option multiplier of 100) if the stock goes to $0. The breakeven point is $18 ($20 strike price - $2 option premium), so you are hoping that the price of XYZ stock falls below $18 before or on expiration.

Short calls and short puts held without an offsetting or “covering” stock or option position are referred to as uncovered, or naked, options. These are significantly high risk strategies and are only appropriate for options traders with the highest risk tolerance. Uncovered short calls are especially risky since you are selling someone the right to buy shares you don’t own at a fixed price.    

For example, let’s say XYZ stock is at $20 and you think it’s going to $5. So you decide to sell (short) one call on XYZ with a strike price of $20, an expiration in January 2018, and the option premium for the contract is $2. You’ll receive a $200 premium ($2 option premium x option multiplier of 100) for selling (shorting) the call. .  If you’re wrong and XYZ rockets to $100 per share before then, the contract could be exercised at any time and you have to sell 100 shares of XYZ for $20 per share. But since the option is uncovered, you don’t own the stock and have to buy 100 shares of stock at or around $100 per share to cover the resulting short stock position. This is why uncovered options require a very high risk tolerance and large amounts of capital to cover positions.

Want to Learn More?

This gives you a basic understanding of some of the differences between calls and puts, but there’s a lot more to know before you decide if different options strategies may fit with your financial goals and risk tolerance.

Whether you’ve been trading for years, or just getting started, register for the TD Ameritrade 2017 Boston Market Drive on Saturday, March 11, 2017. Market Drive is an event designed to develop your market savvy. It’s your chance to share ideas with like-minded traders, hear from industry pros, and learn more about our professional-level trading tools.

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