Understand the difference between puts and calls
Learn the rights and obligations of buying and selling call and put options
Understand the risk and reward profiles of long and short call and put options positions
Options give traders, well, options. But options aren’t just for traders; qualified investors can trade options too. Investors can use options to manage risk and to try to potentially increase returns. Options aren’t 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 types of options: puts and calls. Each has its benefits and risks, and they change depending on if you’re the buyer or seller of a call or a put.
What Are Puts and Calls?
Calls are options that give you the right, but not the obligation, to buy an “underlying” asset, like a stock or index. So if you buy a call option, you have the right to buy the underlying stock or index. If you sell a call option, you assume the obligation to supply the underlying asset when and if the call contract is exercised (more on this later).
So, what is a put? A put option gives you the right to sell the underlying stock or index. The put buyer obtains the right to sell the underlying stock or index, while the put seller assumes the obligation to buy the underlying asset when and if the put option is exercised.
Let’s look at how to go about buying call and put options. We’ll start with calls.
Buying a Call: The Coupon Analogy
Suppose you’re interested in buying a stock, but maybe you don’t want to buy it outright for whatever reason. Instead of buying the shares, you might consider buying a call option that gives you the right to buy the shares on or before a later day (expiration) at a specified price (strike price). So even though you don’t own the shares, you get to “control” a certain number of shares. This gives you the potential to profit (or lose) if the stock makes a move. If the stock moves down, stays the same, or doesn’t go up much, you’ll likely incur a loss in the amount paid for the call option (premium), plus transaction costs.
So before placing an options trade, consider the number of contracts you’re going to trade, the expiration date, the strike price, and the cost of the contract (premium). You can access all this from the Option Chain on the thinkorswim® platform from TD Ameritrade (see figure 1).
FIGURE 1: OPTION CHAIN. On the thinkorswim platform, from the Analyze or Trade tab, you can look at the option chains for different options contracts and identify the strike prices and cost of each. Chart source: the thinkorswim platform from TD Ameritrade.
Buying a call option is kind of like buying a coupon for a dinner at half the price. Say 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. The coupon is now worth more than you paid for it. Although you’re still entitled to the same steak dinner, its value has risen by $5, from $50 to $55. This opens up some choices for you. Suppose your brother-in-law is interested in using the coupon for date night and offers 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 it’ll expire worthless and you’ll lose the $25 you paid for it.
Now, imagine there’s been a huge influx of Kobe beef to the United States. 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 on the open market is lower than the price you paid for the coupon.
Like the dinner coupon, an options contract derives its value from the underlying instrument. That’s why options are included in a subset of financial instruments called derivatives.
The 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. But 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 strike price of the option. Your call option may have some value if the stock price is higher than the strike price of the call, or it may be worthless if the stock price is at or below the strike price.
Selling a Call
What if you decide to sell a call?
Are options the right choice for you?
While options are definitely not 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.
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.
But 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 a 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 the price at which you “struck” a deal. However, there’s still a chance you could be assigned at any time, even if the 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’d be required to sell your shares at the strike price. If you don’t own the shares (called a “naked call”), if assigned, you’d 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 yours to keep no matter what happens. But 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 own the shares, you’ll have to either buy them at the higher (current market) price or hold a short position on 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 on any price movement above the strike price. You could attempt to buy back the option or roll it to another strike or delivery month. This may result in a smaller profit than the credit, or even 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.
Buying and Selling Put Options
Suppose you own shares of a stock and believe the stock’s price is going to fall. You could buy a put that locks in a sale price for a limited time. A put allows you to sell your stock at a set price—the strike price—so that if the stock price falls, you can exercise the put contract. If you don’t own the stock, a put is a bearish vehicle you can use to speculate on a prediction that the stock price 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 position’s value to decline under time decay, making the trade profitable.
If the underlying stock price falls below the strike price, you’ll 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 you 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.
Four Primary Options Strategies
An options contract that gives the buyer the right to buy shares of stock at a certain price (strike price) on or before a particular day (expiration day). For illustrative purposes only.
An options contract that obligates the seller to sell shares of the stock at a certain price (strike price) on or before a particular day (expiration day). For illustrative purposes only.
An options contract that gives the buyer the right to sell shares of stock at a certain price (strike price) on or before a particular day (expiration day). For illustrative purposes only.
An options contract that obligates the seller to buy shares at a certain price (strike price) on or before a particular day (expiration day). For illustrative purposes only.
Here’s a brief summary of how it all fits together: puts and calls, selling and buying calls versus puts, and bullish and bearish biases.
The Up (and Down) Shot
So now we’ve covered some basic concepts of call and put options—definitions for puts and calls, differences between calls and puts, and how calls and puts work. We’ve demonstrated some of the benefits and risks of buying options versus selling options. However, this article only scratches the surface in terms of options strategies. So be sure you’re familiar with these basic strategies for buying and selling call and put options before moving on to more advanced strategies.