Investors and traders alike can explore options by learning how they work, and decide if options are right for their risk level and objectives.
Options give traders, well, options. But options aren’t just for traders; they can give qualified investors options, too. Investors use them to manage risk and try to potentially increase returns. Options are not suitable for everyone, however, as they involve significant risks.
Options are typically used to speculate on the direction of the market, hedge against market downturns, or pursue an additional income goal. This is why many active traders add them to their arsenals.
First, the basics. There are two option types: call options and put options. Each has its benefits and risks, and these change depending on if you’re the buyer or seller of a put or call option. Let’s start with calls.
Suppose a trader is interested in a stock but isn't sure if she wants to buy outright, but instead decides to "control" a certain number of shares. 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. If the stock moves down, stays the same, or does not go up much, our investor will incur a loss in the amount she paid for the call option, plus transaction costs. The cost of the option is called 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 options are included in a subset of financial instruments called 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 in time value ("theta" in options parlance) until it expires. At that point the option will be worth the difference between the stock price and the option’s strike price. Your call option may have some value, if the stock price is higher than the call's strike price, or it may be worthless, if the stock price is at or below the strike price.
Now, what if you decide to sell a call? Let’s start by rephrasing the definition of a call option.
As the seller of a call option, you're bearish or at least neutral on the underlying stock because you’re predicting the stock will go down.
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 can work to your benefit. If you sold a call that obligates you to deliver shares of the stock at $50, as long as the stock price stays below $50, you likely won’t have to deliver shares. This agreed-upon price is the strike price—that’s price at which you “struck” a deal. However there's a chance you could be assigned at any time, even if stock price is below the strike price.
It's also important to note whether or not you own the underlying stock. If so, it's known as a "covered call" and, if assigned, you would be required to sell your shares at the strike price. If you don't own the shares (called a "naked call"), if assigned, you will need to buy the shares in the open market in order to deliver them. Either that, or you could hold them as a short position.
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 deliver the shares at the strike price. If you don't possess the shares you'll have to either buy them at the higher (current market) price, or hold a short position in the stock. And, theoretically a stock price could climb forever, so there's unlimited risk with this strategy.
If you do have the shares in your account (a "covered call"), then you would have missed out any price movement above the strike price. You could, however, attempt to buy back the option, or roll it to another strike or delivery month. This may result in a a smaller profit than the credit or a loss, and will incur additional transaction costs.
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.
Imagine a trader is owns shares of a stock and believes the stock’s price is going to fall. So, he buys a put that locks in a sale price for a limited time. 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 a prediction that a stock will fall. Puts increase in value as the underlying stock price falls. But, remember, as time passes, options depreciate in time value. As the stock price increases, the value of a put falls.
When you sell a put, you’re bullish. Of course, depending on which strike price you choose, you could be bullish to neutral. Some traders may simply want the stock price to stay above the strike price and the option value to decline under time decay, making the trade profitable.
If the underlying stock price falls below the strike price, you will likely be required to buy the shares of stock at the strike price. This could require a substantial amount of money. If it’s a stock you’d like to own, then selling puts can be one way to attempt 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.
For a brief summary of calls and puts, buying and selling, and bullish and bearish biases, refer to the table below.
These are some of the basic concepts of call and put options, including definitions for calls and puts. We've demonstrated some of the benefits and risks to buying options versus selling options. However, this article only scratches the surface in terms of options strategies.
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A long call or put option position places the entire cost of the option position at risk. Should an individual long call or long put position expire worthless, the entire cost of the position would be lost.
The risk of loss on an uncovered call option position is potentially unlimited since there is no limit to the price increase of the underlying security. Naked option strategies involve the highest amount of risk and are only appropriate for traders with the highest risk tolerance.
The naked put strategy includes a high risk of purchasing the corresponding stock at the strike price when the market price of the stock will likely be lower. Naked option strategies involve the highest amount of risk and are only appropriate for traders with the highest risk tolerance.
With the protective put strategy, while the long put provides some temporary protection from a decline in the price of the corresponding stock, this does involve risking the entire cost of the put position. Should the long put position expire worthless, the entire cost of the put position would be lost.
The cash secured put strategy risks purchasing the corresponding stock at the strike price when the market price of the stock will likely be lower.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
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