Options Trading 101: Understanding Calls And Puts
- Options allow you to make money in the stock market regardless of whether it’s up, down or stagnant
- The two varieties of options, calls and puts, can be combined in several different ways to anticipate the increases or decreases in the market, decrease the cost basis of a trade or mitigate the risk options trading poses
- Trading options can be risky, so it’s best to practice trading on paper before you use real money
Most people know that you can make money in the stock market when the prices of equities are rising and the economy is doing well. But what about when economic times are uncertain?
Rather than sitting on the sidelines, you can use alternative approaches to make money during a down market. One of these strategies is trading options. Options come with more risk than buying and holding stocks, but this can be minimized with proper planning. Better yet, your returns could be much more than what appreciating stocks offer.
Here’s how to invest in options, and how Q.ai can help you invest in general.
What is an option?
An option is a right, not an obligation, to buy or sell a specific stock at a designated price before a particular date. Options come in two varieties, including calls and puts. The concepts involved are relatively simple, but keeping track of which one is which and when each should be used can get complicated.
If you want to skip all the mental gymnastics involved in trading options, you can opt for Q.ai’s Short Squeeze Investment Kit. Otherwise, if you’re interested in understanding how options work so you can use them in your portfolio, here’s what you should know.
What is a call?
A call is a type of options contract where the buyer bets that the stock price will increase. The buyer has the right to purchase shares (or “call them away”) at a predetermined price called the strike price. The buyer can exercise this right if they choose.
However, regardless of whether or not the option is exercised, the buyer must pay a fee for this, which is called a premium. The call option is only good until its expiration date. If it’s not exercised before then, it no longer has any value to the holder.
How are calls used?
Calls can be bought or sold, depending on the option trader’s goals and expectations. Generally, the buyer of the call anticipates that the underlying stock price will rise and uses the call to lock in a discounted price.
“Going long” on a call or being in a “long call position” means you own the option, or in the case of a call, the right to buy shares at a specific price.
Here’s an example. Marco wants to own XYZ stock, which is trading at $100 per share. XYZ’s Q3 earnings announcement is next week. He thinks XYZ will jump 20% after the announcement, but he is short on cash since he doesn’t get paid until next month. Not wanting to lose out on the rise in price, he buys a long call option with a strike price of $100 per share.
Marco might pay a premium of $3 per share for his call option. Options contracts come in increments of 100 shares, so his call option will cost him $300. However, if the stock moves the way he wants it to and increases by 20%, he can exercise his call option and get a $120 stock at a $100 price minus the premium he paid. This will net him $1,700 ($17 per share).
Note that if the stock price doesn’t move the way Marco expects and instead stagnates or decreases, Marco will be out the $300 he paid for the option.
“Going short” or being in a “short call position” indicates that you are the seller of the call, so someone else has the right to call away your shares at the strike price until the option expires. Short calls can be a great way to make money on a stock you already own, even if the price of the stock is going down.
To illustrate, let’s say Amelia buys 100 shares of ABC stock that is trading for $50 a share. However, it’s in the tech industry, which is currently struggling. She thinks her shares will recover in a few years, but she’d like to make some money on them in the interim. Amelia writes a short call on ABC at $60 per share with an expiration date one year from now. She is confident ABC will continue declining for a while, or it at least won’t go up much in the next year.
When Amelia sells the call on her stock, she’ll collect a premium of $2 per share, earning her $200. If her prediction is correct, she’s made $200 for doing essentially nothing. If her prediction is incorrect, she must sell her shares. However, because she bought them at $50 and sells them at $60, she’ll still make $10 per share, plus the $200 premium, so it’s a win-win scenario.
Covered vs. Uncovered Calls
It’s worth noting in the above example that the call option Amelia sold was covered by her shares. This is known as a covered call and carries much less risk than an uncovered call.
Instead of selling a call on shares she owned, imagine that Amelia sold an uncovered call without any shares to back it up. If Amelia is right and the stock doesn’t rise above $60, she makes $200 for no investment. This is an incredible rate of return.
However, if she is wrong, she carries a substantial risk. ABC stock could (theoretically) go up infinitely high. If the owner of Amelia’s call exercised their option, she would have to pay whatever price the market designated to meet her obligation. Her losses could be catastrophic if the stock price shoots up.
Beginners should stick to long calls, covered calls or other methods to mitigate the risk of an uncovered call.
What is a put?
In some ways, puts are the opposite of calls. The buyer of a put anticipates the stock price of the option to go down, so they want to lock in the high price before it falls. The buyer of the put gets to sell their shares at a specific price.
How are puts used?
Puts are often compared to insurance. This is because if your stock’s price tanks and you’ve bought a put, you mitigate your loss to just the price of the put’s premium. On the other hand, short puts can be used to offset the price of buying a stock.
Here’s an example of a put option in action. Joe bought the same ABC stock Amelia did at $50 per share. He also thinks it will go down, so he buys a put to protect his investment. This strategy is known as a protective put or a married put. His strike price is $50, and he pays $1.50 per share as a premium for a total of $150. The option expires in six months.
ABC stagnates for a while, then falls to $4 a share three months later. Joe exercises his put option and sells his shares at his strike price of $50. The only money he lost was the $150 premium. If he wants, he can buy back his shares at the market price of $40, making him $8.50 per share ($50 strike – $40 share price – $1.50 premium = $8.50 profit).
If Joe is wrong and ABC goes up, he does not need his put option and is out $150 (much like an unused insurance policy). However, he also knows he won’t be out more than that if the stock price drops significantly.
The writer (or seller) of a short put intends to make money on the increase in stock price without actually purchasing the stock. Let’s look at an example.
Marco’s friend Grace is also short on cash. Like Marco, Grace thinks XYZ stock (currently $100 per share) will go up after the Q3 earnings announcement. However, she thinks $100 is too expensive for XYZ, and she’d much rather buy it at $85 per share. Given this, she writes a short put at the $85 strike price and earns $2.50 per share.
If Grace’s option gets exercised, she keeps the $2.50 per share premium and gets the stock at a price she likes. If the option expires, she keeps the premium without any cash outlay.
Note that short puts are less risky than short calls, but not by much. The lowest a stock price can go is $0, so the risk that the writer of a naked (or uncovered) put has is the full strike price of the underlying stock.
In writing a short put, Grace’s risk is that she must pay $8,500 for 100 shares of a stock that goes down to $0. This is unlikely but possible, so she must account for that risk when selling the put option.
Common call and put combinations
Calls and puts can be combined in various combinations for several investment goals. Here are a few strategies commonly used by options traders.
Bullish call spread
If you’re moderately bullish on a particular stock, you might buy a call at the current price (say $100) and sell an out-of-the-money call at $110. Both calls expire at the same time and have the same underlying stock.
This strategy reduces the cost of procuring a call option and protects you from loss. The premium you’d get from the short call (say $1.50 per share) offsets some of the cash outlay you’d make (perhaps $3 per share). This means that the whole trade will cost you $150 ($3 long call – $1.50 premium for short call = $1.50 x 100 shares).
While the cash requirements for this trade are minimal, the profit is also capped at $10 per share minus the $1.50 you are out for the calls, which equals $8.50 per share. With a call spread, you don’t have to buy the stock to realize the gains, but those gains are capped.
Bearish put spread
This strategy works as an inverse to the bullish call spread. When you predict a stock will go down, you buy a put with a higher strike price and sell a put at a lower strike price, both with the same expiration.
Much like the above strategy, the function of this approach is to decrease the cost of the options for the trade-off of sacrificing any outsized gains. As with the call spread, the maximum risk is the cash laid out for the long put minus the premium of the short put. The maximum profit is the difference between the strike prices minus the cash outlay.
You might use a protective collar strategy if you own the underlying security and want to protect against severe losses while making some money when the stock goes up. In a protective collar, you buy a protective put and sell a short call.
The put safeguards your asset from losing value past the given strike price. The call allows you to collect a premium if the stock price doesn’t move or sell your stock at a profit at the call’s strike price.
There is an opportunity cost to using a protective collar since you’ll lose out if the stock gains value past the strike price of your short call.
If big moves are coming to your stock of choice but you’re unsure of whether they will be up or down, a long strangle could be a good strategy to implement.
This costs a bit more because you buy both a long call above the currently traded price and a long put below (both for the same expiration date). You’re paying for two options contracts with no premium from a sold option contract to make the deal cheaper.
However, if the stock rises far above your call strike or falls below your put strike, you can profit in either case as long as the rise or fall is enough to cover the cost of the options you paid for.
A long straddle is quite similar to a long strangle. The main difference is that instead of buying out-of-the-money options, you buy a long call and a long put at the same strike price, which is equal to the currently traded price.
With this strategy, the options will cost more since they’re at the money. However, you also don’t have as far up or down for the stock price to go to make the deal profitable.
The bottom line
This list of options strategies isn’t anywhere near comprehensive. There are dozens of combinations to fit every stock, investor and market condition.
Before jumping into trading options, beginners should educate themselves and practice paper trading. While the lower price point of options trading can be alluring, it comes at a higher level of risk that must be managed wisely.
If you want to take advantage of options trading without all the monitoring and education required, consider using Q.ai. Using artificial intelligence, Q.ai finds hidden opportunities to profit from options traders and hedge funds shorting stocks.
Download Q.ai today for access to AI-powered investment strategies.
Source: Fox Business
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