Buying and selling shares of stocks is pretty straightforward. Owning stock means that you are buying an equity position in the company. Investors buy stock in the hopes that the price will appreciate and perhaps to earn any dividends the stock might distribute. Stocks can be sold at either a gain or a loss depending upon the price activity while you own it.
Options on the other hand represent a contract that gives you the right, but not the obligation, to buy or sell shares of a stock, an ETF or another underlying security at a specified price. One option contract will generally cover 100 shares of the underlying stock.
Options have an expiration date after which you can no longer exercise them to buy or sell the underlying shares. The cost to purchase an option is called a premium. If you don’t exercise the option you would forfeit the cost of the premium.
What you can do with an options contract
Exercise the option
In options trading, "to exercise" means to put into effect the right to buy or sell shares of the underlying stock at the specified price by the expiration date. This generally makes sense if the exercise price of the option is advantageous when compared to the current market price of the stock or other securities covered by the option.
Sell the option
You can sell the option to another investor. It is not uncommon to trade options for those who know what they are doing this can be profitable unto itself.
Let the contract expire without exercising.
This would generally occur if the exercise price is unfavorable compared to the market price of the security.
Types of options contracts
A call option gives the holder the right to buy shares of the company’s stock at a specific price (known as the strike price) within a set time period.
A put option gives the option holder the right to sell shares of the underlying stock at the strike price for a specified period of time.
Terms associated with options you should know:
- In the money: A call option is in the money if the option’s strike p+
- At the money: If the strike price and market price of the stock are the same then the option is considered to be at the money. This applies to both call and put options.
- Out-of-the-money: An option is considered to be out-of-the-money if the share price of the stock is lower than the strike price for a call option and if it is higher than the strike price for a put option.
- Premium: The price you pay to buy a call or put option is called the premium.
- Derivative: Options are a type of investment known as a derivative. A derivative’s performance is tied to that of another type of financial instrument, in this case that is the performance of the underlying stock.
- Spreads: Spreads are an advanced options trading strategy that involves the trading of multiple options on the same underlying security.
Trading strategies used by investors
A long call is simply buying a call option on a particular stock. Call options can be a means to speculate on the price movement on a particular stock.
Buying an in the money call option allows you to purchase 100 shares of the underlying stock at the strike price. Buying the shares at a level below the current market price can build in an instant profit for the investor.
Additionally, the options themselves can be sold. Depending upon the direction of the share price of the underlying stock, the price of the option might increase over time. The risk of buying a call option is that it can expire without your having exercised it or having sold the options. In this case you would be out the premium that was paid for the option. This is often less risky than holding the actual shares of the stock if the share price decreases as your investment in the shares is likely to be higher than the cost of the option premium.
Covered call option
Under this strategy the investor owns the stock and then writes (sells) a call option on the shares as well. This can be done at the same time the shares are purchased or the option can be written on the shares of stock at any point you hold them. The objective is for the investor to earn some extra income from the premium earned from selling the option.
If an investor has held the shares for a while and they’ve appreciated, a covered call strategy can be a way to generate income. By writing calls with an out-of-the-money strike price, there is a good chance they will expire worthless. If the option does end up being exercised it's likely the investor will still have generated a decent profit from having held the shares over time.
A buy-write strategy is a variation on the covered call. In this case the investor buys shares of the stock and at the same time sells a covered call on the stock. The purpose of this strategy is to derive income form the option premium earned from selling the call option.
Ideally the investor will want to sell a call option with a strike price significantly above the current market price of the underlying stock. There is a balance here. You will want the strike price to be high enough to not be triggered by normal fluctuations in the share price. However, you do not want the strike price to be so high that the option premium will be fairly negligible.
Short or naked call
This is a risky strategy. The investor sells a call option, generally you will want to sell the call at a strike price below the current market price of the underlying security. Ideally you will want the call to expire worthless, your profit will come from the premium received from selling the call option.
Investors using this strategy generally feel bearish to neutral about the underlying stock or ETF. Since you don’t own shares of the underlying security, this can be a risky strategy. If the stock shoots up in value and exceeds the strike price, you will need to go into the market and purchase shares at the prevailing market price.
The probability for this strategy to be successful can be high if the calls sold are solidly out-of-the-money.
In this scenario, the investor would purchase a put option on the underlying stock. Buying a put option is a bet that the price of the underlying stock will decline. Buying a put option is a less risky way to bet on the decline of the share price than selling shares of the stock short.
The main difference in the two alternatives is that when selling short your risk is virtually unlimited if your bet on the stock’s decline is wrong. You will have to cover the short position regardless of what direction the share price has gone. If the price increased you could be faced with having to go into the market and purchase enough shares to cover the short position at a very high cost.
By using a put option to bet on a price decline, the most you will be out is the cost of the option premium if the price increases instead.
A short put is also known as a naked put or an uncovered put. Selling a put option obligates you to buy the number of shares covered by the put option.
The main objective in selling a put option is to earn the income generated by the option premium from the buyer of the option. When using this strategy, you will want to do your analysis first to try to determine how likely you believe it is that the stock price will remain above the option’s strike price. The risk is that your bet is wrong and that you have to purchase the shares at the strike price which could be above the actual market price of the stock.
If you are looking to use this strategy, it is a good idea to have a stop-loss strategy in place to ensure that you are not faced with the prospect of having to purchase the shares at the option’s strike price if your bet on its direction is significantly wrong.
In this strategy the investor will:
- Sell an at-the-money put option
- Buy an out-of-the-money put option
- Sell an at-the-money call option
- Buy an out-of-the-money call option
All of these transactions would be on the same underlying security and would all have the same expiration date.
This strategy uses two spreads on the underlying stock. There is both a short put and a short call strategy. The out-of-the-money call and put options provide downside protection. This strategy can provide a decent amount of income from the option premiums and sometimes a small gain on the stock. As will all multi-faceted options strategies, it is important to understand the implications of the four options used in this strategy both separately and in combination with each other.
This strategy is complex utilizing four different options contracts all with the same expiration date but with different strike prices.
To construct an iron condor strategy, the investor would:
- Sell an out-of-the-money call option.
- Sell an out-of-the-money put option.
- Buy a further out-of-the-money call option.
- Buy a further out-of-the-money put option.
Each of these options would have the same expiration date and each would have a different strike price.
An investor might consider this strategy if they think that the price of the underlying security will not move much by the expiration date, and they want to limit their risk exposure.
Typically the investor will structure the strategy when the market price of the stock is roughly half-way between the strike price for the two options that are being sold. If the market price is closer to either strike price, then the strategy will have either a bullish or bearish tilt with regard to the investor’s theory of the direction of the stock price.
A trader will try to position the strike prices of the options they’ve sold relatively close together to produce a higher net credit and earn a small profit on the transaction, but still far enough apart where there would be a strong probability of the stock’s price settling between these two strike prices by the expiration date.
Bull call spread
In a bull call spread, the investor simultaneously purchases one or more call options at a specific strike price and sells the same number of call options at a higher strike price. Both call options will have the same expiration date.
This type of spread might be used when an investor feels bullish about the prospects of the underlying stock but expects a moderate increase in the price of the underlying asset.
For this strategy to be successful, the investor needs the underlying stock to appreciate in price in order to show a profit on the transactions. The profit is limited if the stock price increases above the strike price of the call option that was sold, the potential downside risk is limited if the stock price falls below the strike price of the long call option.
The maximum profit on the transaction is the difference between the strike prices on the options that were purchased and the options that were sold, minus the net cost of the spread between the premiums for option purchased and the option sold less any commissions times the number of shares covered by the options.
Bear put spread
With a bear put spread, the investor purchases put options at a specific strike price and simultaneously sells put options at a lower strike price. Both transactions involve options on the same underlying stock or other security. All options will have the same expiration date.
A bear put spread would be used when the investor has a bearish sentiment about the underlying security. This strategy offers the potential for limited gains, and limits downside risk if you are wrong on the underlying stock’s direction.
You would buy a put with a strike price below the stock’s current market price. You will make money if the stock’s price falls below this strike price.
You would sell a put option on the same security at an even lower strike price. The price you receive from the sale of this put option would offset some or all of the premium that you paid for the put option(s) that you purchased.
Ideally the price of the stock or ETF falls as you had anticipated and both puts are in the money upon their expiration.
In a protective put the investor buys or already owns the underlying security and then buys a put option(s) on some or all of the shares of the underlying security that you want to protect with this strategy.
In a situation where you own 100 shares of a given stock and purchase one put option against those shares, if the stock price declines you are protected against any decline below the strike price of the put option. This protection only lasts until the expiration of the put option.
Your maximum profit on this strategy is limited only by the amount that the underlying stock or ETF might appreciate in value. Your maximum risk is the current share price less the strike price less any commissions on the transaction.
A protective put might be used as an alternative to a stop-loss order. With a stop-loss order you have no control over the exercise in the event of a sudden, steep decline in the security’s share price. With a protective put, you have control over when and if the put option is exercised. The flip side is that a stop-loss order has no cost involved with placing it, buying the put option does involve the cost of the premium on the option.
A protective collar involves purchasing an out-of-the-money put option and then simultaneously writing an out-of-the-money call option on the same underlying security all with the same expiration date.
This strategy might be used by an investor in a stock that has experienced sizable gains and they want to protect those gains. Investors might choose this strategy for two main reasons:
- To limit risk when initially acquiring the shares, this strategy is known as a “married put” if utilized under those circumstances.
- To protect an existing stock position when the near-term outlook for the stock is somewhat bearish, but the longer-term outlook is bullish for the security.
The upside potential in this strategy is virtually unlimited as it is tied to the upside potential of the price of the stock or underlying security. The premium paid for the put would serve to reduce that profit potential a bit.
The downside protection of this strategy comes from the put option which provides price protection for the underlying shares at a level below the strike price. This protection lasts until the expiration date of the put option.
There are a wide range of options trading strategies to accomplish a wide range of objectives that an investor might have. Options can be used to hedge a position in a security that you own, or they can be used to speculate on the price of an underlying stock or other security.
Option strategies can be quite aggressive or rather conservative. Money can be made from writing an option. It’s important that investors understand how a particular strategy they are considering works, especially the downside risk involved, before tying it.
For sophisticated investors, options can present an opportunity to enhance the value of their portfolio and hedge against some of the downside risk inherent in their portfolio. In some cases, investors can make a tidy profit simply from trading options contracts.