Considering options trading? Start with the basics of puts and calls and how to create single-leg strategies with call and put options.
When you try something new, you may not necessarily get it right away. It may take some repetition, but with tenacity, you’ll likely reach a point where things start to come together. Before jumping in to options trading strategies, it’s best to start with the basics of call and put options.
Why trade options? They can be useful in a variety of circumstances and market scenarios. Some options strategies can be quite complex, which is why it’s best to start with the most basic strategy. Let’s look at a couple fundamental options strategies to help you become more familiar with trading options.
Like all our strategy discussions, the following 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 standard stock or equity options, each contract delivers 100 shares of stock. Non-standard options may have different deliverables so make sure you understand the terms before trading.
For more on the basic terminology and mechanics of options contracts, please refer to this primer.
Buying calls as a stock alternative. Buying a call option is considered a bullish strategy because the call options price typically rises when the price of the underlying security rises. Similarly, call prices typically fall when the underlying falls. The premium paid for an option is typically a fraction of the price of the underlying. Traders or investors who have a directional view might consider buying a call option as a lower-cost alternative to buying a stock outright. But there are some differences between an option and a stock that are important to note. 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 typically lower-cost substitute for stock, they use 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. But keep in mind that the call can be exercised at the will of the owner (buyer) of the call option at any time up until expiration. If the call is in the money (ITM) on or before expiration, the likelihood that the owner of the option will exercise his or her right to buy the underlying at the strike price increases. And that means you may be required to deliver your stock. Keep in mind, however, that the short (sold) option can be exercised at any time regardless of the ITM or out of the money amount.
Using the data from the table, let’s look at an example: Suppose you own 100 shares of a stock that’s trading at $79.34. Say 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.
Example of an option chain. Theoretical prices for options with 35 days until expiration. For illustrative purposes only.
Suppose you sell the 82.5 strike call at the bid price of $2.37. You’d collect $237 of premium ($2.37 x 100), minus any transaction costs. If the stock stays below $82.50 between the time you buy it and expiration, the call will most likely expire worthless and you realize the $237 premium; this is what some call an “income enhancement” to the stock you own.
But what happens if the stock rallies above $82.50? You may be required to deliver your stock at $82.50 per share. Remember, the stock was at $79.34 when you sold the call option and took in $237 of premium. So, if the stock stays below $82.50 (and the call option expires worthless), you earned some income from your stock. If the stock rallies above $82.50 by expiration, your return is capped at $553 ($237 premium + $316 stock gain), minus transaction costs. The risk curve will look similar to what you see in figure 1.
FIGURE 1: RISK PROFILE OF COVERED CALL. A covered call with the stock at $79.34 and the 82.5 strike call sold for $2.37. Chart source: The thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.
For all these examples, remember to multiply the options premium by 100, the multiplier for standard U.S. equity options contracts. So, an options premium of $1 is really $100 per contract.
Although the covered call can be used to potentially generate income from a stock, there’s another basic strategy that can help limit potential losses on a stock you already own—a protective put. Buying a put option is a bearish strategy because the price of a put 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 at any time up until expiration. If the long put expires worthless, the entire cost of the put position would be lost. This strategy provides only temporary protection from a decline in the price of the corresponding stock.
If you’re bearish on a stock, you might consider buying a put in lieu of shorting the stock. Shorting stock can be quite risky because there’s no cap on the potential losses—a stock can theoretically rise to infinity. But with the protective put, you’re not necessarily buying the put because you think the stock is going to drop, but rather in case the stock were to drop.
Let’s look at another scenario. Using the example from the table, say you own the stock, but you’re not comfortable with the thought of it dropping below $77.50. Maybe you want to protect profits or perhaps $77.50 represents a price support level on the price chart. Either way, paying $2.76 ($276 per contract) for the 77.5 put means you cap your loss at $4.60 if the stock falls below $77.50 on or before the expiration date of the option. That’s the difference between the current stock price and the strike price ($79.34 – $77.50 = $1.84), plus the premium for the put ($2.76). And don’t forget to add 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. Your losses are limited with the stock below $77.50. See figure 2.
FIGURE 2: RISK PROFILE OF PROTECTIVE PUT. A protective put with the stock at $79.34 and the 77.5 strike put purchased for $2.76. Chart source: The thinkorswim platform. For illustrative purposes only. Past performance does not guarantee future results.
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 options strategies can be used for.
While options trading involves unique risks and is definitely not suitable for everyone, if you believe options trading fits with your risk tolerance and overall investing strategy, TD Ameritrade can help you pursue your options trading strategies with powerful trading platforms, idea generation resources, and the support you need.
Learn more about the potential benefits and risks of trading options.
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Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.
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