Understanding Call and Put Options
One of the key things to know about options is that each contract represents 100 shares of the underlying stock. If you sell an option contract for $1.00, that’s really per 100 shares, so you really sold $100 of actual value. Every option strike and expiration has its own price which is derived through the Black-Scholes option pricing model. The primary factors that affect option prices are the stock’s price and how much time left until the expiration date. As the stock price changes, the options price will change with it.
A call option that is purchased allows the buyer to buy 100 shares of stock at the contract’s expiration and strike price chosen if the stock price closes above the strike price. This is called being in-the-money. Just like a stock, you can short a call, which would obligate you to provide 100 shares of stock at that strike price. If you own 100 shares and sell a call, you are willing to be “called away” at that strike price if the stock closes above that level at expiration. This is the flip side of being the option buyer and then buying 100 shares at the strike price as shown above. If the stock drops in price, the value of the call option will drop as well since the stock is cheaper to buy on the open market, making the option worthless.
Long Call Option Example
When you buy a call, you pay a debit to open the position because it costs money to own the contract. To make money you must be right directionally on the stock going higher, before expiration. The max you can lose is the amount you paid for the option and your max profit is theoretically unlimited because there is no ceiling to how high a stock price can go. This is the allure of long calls.
With Apple (AAPL) trading at $142 per share, I could buy a 140 strike call option expiring in 40 days for about 7.00 or $700 per contract. This allows me to participate in upside appreciation in AAPL with limited downside risk of what I paid for the option. The downside is that I need AAPL to rally higher in the next 40 days and since I paid for the right to buy shares at 140, the theoretical breakeven is at 147.00, which is 140+7.00. I need the stock price ABOVE 147 at expiration just to be profitable. Of course the trade works great if the stock rallies higher and becomes in the money but for this discount of paying just $700 to have exposure to the upside, you have to combat the time decay portion of a long option. For each day that passes and the stock does not move, a little bit of the premium evaporates from the option. So I need AAPL to go up enough to offset the time decay. The time decay of an option is called theta or extrinsic value, which we will talk about shortly.
Options are attractive because of the leverage they offer but it’s crucial to understand they are tied to expiration dates and when you buy an option you could lose 100% of the premium paid. But you can also position size accordingly so you are only risking what you are comfortable with while using a fraction of the money you would be putting up to own 100 shares. So when buying long options you need the stock price to move in your favor and preferably in a fast nature, otherwise since time is constant, the decay of the contract starts to accelerate closer to expiration.
Long Put Option Example
Just like a call option, a put option is equivalent to 100 shares of stock, but puts allow the owner to sell stock at the strike price rather than buy it. As a result, if you own a long put you want the price of the stock to go lower. Instead of buying a call for speculation to the upside, traders will usually buy puts for speculation to the downside or to hedge long stock positions.
Many investors will use put options as a way to protect their downside, but this isn’t free. Just like any other form of insurance you will have to pay up to own that protection, and often put options are more expensive than call options because of the built in implied volatility skew. This simply means the market prices in the velocity of risk to one side and with stocks that usually is to the downside since stocks fall much faster than they rise.
If I wanted to bet on Apple (AAPL) falling in price I could purchase a long put option. With AAPL currently at $142 I could buy the 140 strike put expiring in a little over a month for about $7.00 or $700 per contract. If AAPL stock falls substantially below the 140 level, I am profitable but I need the stock to fall enough to offset the time decay component of the option price. I need the stock price BELOW 133 at expiration just to be profitable since we paid $7.00 for the right to sell shares at 140. Often it is more difficult to speculate on downside moves with put options since they are generally more expensive than their counterpart, call options. Much like calls there are lots of other factors or “greeks” that affect the price of a put option but directionally this is how put options function.
Shorting Puts and Calls
Another way to trade options is to sell them, or short. When you buy an option you are buying the right to buy or sell at a specific price before an expiration date. But when you sell an option you are entering into an obligation to buy or sell at that specific strike price before expiration. Again there are a lot of reasons why an investor might want to short an option versus buying them but it can be a higher probability trade with limited payout. Remember when you sell options you are betting against stock price movement in one direction or the other.
Selling a call against shares that you own is known as a covered call and is a way to add yield to an investment while still owning shares and being willing to sell at the strike price you sold the call option at. When someone owns 100 shares of a stock they can sell 1 call option and collect a credit or premium for that sale. If the stock rallies through and closes above the strike price at expiration, the stock is “called away” and you agree to sell shares while keeping the premium you collected. This is a great way to add to your return if you were wanting to sell your stock already anyway at a specific price.
Selling a put or being short a naked put is just taking the opposite side of the ‘long put’ example above. When you sell a put option to open, you are willing to buy 100 shares of stock at the strike price at expiration if the stock closes below. If the stock stays sideways or goes up, you keep the premium collected for selling that put. Either being able to buy back the short put or letting it expire worthless. This is a high odds way to enter a stock you want to own as long as you position size appropriately and sell put options at favorable price levels. The risk profile of selling a naked put is the EXACT same as selling a covered call but often uses less buying power because you aren’t obligated to buy shares initially, or if the price closes below your strike price that was sold. Since put options are notoriously overpriced due to volatility skew, this is a way to enhance your return versus just buying 100 shares of stock at the current market price.
- Purchasing a call option allows you to buy 100 shares of stock at the strike price. A rise in the stock price benefits a long call option.
- At expiration, the stock price needs to be higher than the strike price plus the premium paid for the option in order for the call option buyer to be profitable.
- Selling a call allows you to bet against movement in the stock or enhance yield using covered calls against stock you already own and don’t mind selling.
- Buying a put option allows me to sell 100 shares of stock per contract at the strike price.
- At expiration, long put options are profitable only if the stock price is below the strike price chosen by more than it cost to buy the put option.
- Being short a put option obligates me to buy 100 shares or also known as being assigned at the strike price at expiration.