Though some option strategies are quite complex, options education begins with the basics of calls and puts.
Before learning to run, you had to first crawl, then walk. Before penning that masterpiece, the writer needed to learn the ABCs. And before jumping into options trading strategies, you need to learn the basics.
For many traders and investors, options can be useful in a variety of circumstances and market scenarios. Although some option strategies are quite complex, sometimes the most basic strategy is all an investor might need. Let’s look at a couple of the fundamental option strategies to help you decide if options may be right for you.
The following, like all of our strategy discussions, is strictly for educational purposes. It is not, and should not be considered, individualized advice or a recommendation.
A long call option gives the owner the right, but not the obligation, to buy the underlying security, at a specific price (the “strike” or “exercise” price) on or before a specific date (the “expiration").
A put option gives the owner the right, but not the obligation, to sell the underlying security. For stock, or equity options, each contract delivers 100 shares of stock.
For more on the basic terminology and mechanics of option contracts, please refer to this primer.
Buying calls as a stock alternative. Buying a call option is considered a bullish strategy because the call option price typically rises when price of the underlying security rises. Call prices also typically fall when the underlying falls. And because the premium paid for an option is typically a fraction of the price of the underlying, you can see the appeal for some traders. If an investor has a directional view, he or she might consider buying a call option as a lower-cost alternative to buying a stock outright. It's important to note, however, that an option is not a stock. Stocks don't expire, whereas options do. If you buy an option and it expires worthless, you lose your entire investment. Plus, options don't carry voting rights, nor do they pay dividends.
Selling calls for potential income. Some option traders turn to call options when they already own the stock. Instead of using calls as a cheaper substitute for stock, they’re using calls to potentially generate income on shares they already hold. This strategy is called a covered call and involves selling the option rather than buying it. When you sell a covered call, instead of paying a premium, you receive the premium. The risk, however, is if the call is in-the-money on or before expiration, the owner of the option will likely exercise his or her right to buy the underlying at the strike price, which means you may be required to deliver your stock.
Using the data from the table below, let’s look at an example. Suppose you own 100 shares of a stock that's currently trading at $70. Suppose you’re bullish long-term, but don’t think the stock will move much higher over the next several weeks. So you create a covered call by selling a call option against your stock.
For all of these examples, remember to multiply the option premium by 100, the multiplier for standard U.S. equity option contracts. So an option premium of $1 is really $100 per contract.
Suppose you sell the 71-strike call at the bid price of $0.90. You’d collect $90 of premium ($0.90 x 100), minus any transaction costs. If the stock stays below $71 between now and expiration, you keep the premium; this is what some call an “income enhancement” to the stock you own.
On the other hand, If the stock rallies above $71, you may be required to deliver your stock at $71 a share. But remember, the stock was at $70 when you sold the call option. Plus, you took in $90 of premium. So if the stock stays below $71, you earned some income from your stock. If the stock rallies, your return is capped at $71.90, minus transaction costs. See figure 1.
FIGURE 1: RISK PROFILE OF COVERED CALL.
A covered call with the stock at $70 and the 71-strike call sold for $0.90. For illustrative purposes only.
So, while the covered call can be used to potentially generate income from a stock, there is another basic strategy which can help limit potential losses on a stock you already own. It’s called a “protective put.” Buying a put option is a bearish strategy because a put price tends to rise as a stock price falls, and vice versa. Recall that a put gives the owner the right but not the obligation to sell the underlying at the strike price.
If a trader is bearish on a stock, they may consider buying a put in lieu of shorting the stock. Shorting stock can be quite risky since there’s no cap on the potential losses—a stock can theoretically rise to infinity. But, with the protective put, the trader is not necessarily buying the put because he or she thinks the stock is going to drop, but rather in case the stock were to drop.
Let's look at another example. Suppose you own the stock from our table above, but you’re not comfortable with the thought of it dropping below $68. Maybe you want to protect profits, or perhaps $68 represents a price support level on the chart. Either way, paying $0.75 ($75 per contract) for the 68 put means you cap your loss at $2.75 if the stock falls below 68 on or before the option's expiration date. That’s the difference between the current stock price and the strike price ($70-$68=$2), plus the premium for the put ($0.75). And don’t forget to add in those transaction costs!
In this example, you’ve capped your risk to the downside, but you can still profit if the stock continues to rise. See figure 2.
FIGURE 2: RISK PROFILE OF PROTECTIVE PUT.
A protective put with the stock at $70 and the 68-strike put purchased for $0.75. For illustrative purposes only.
Although call and put options are certainly used to make directional plays on a stock, their uses go beyond that. And potential income generation and stock protection, as we demonstrated above, only scratch the surface of what option strategies can be used for.
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