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Much like stocks, options can be used to take a position on the market in an effort to capitalize on an upward or downward market move. Unlike stocks, however, options can provide an investor the benefits of leverage over a position in an individual stock or basket of stocks reflecting the broad market. At the same time, options buyers also can take advantage of predetermined, limited risk. Conversely, options writers assume significant risk if they do not hedge their positions.
An option is the right, but not the obligation, to buy or sell a stock (or other security) for a specified price on or before a specific date. A call is the right to buy the stock, while a put is the right to sell the stock. The person who purchases an option, whether it is a put or a call, is the option "buyer". Conversely, the person who originally sells the put or call is the option "seller."
The price of an option is called its "premium". The potential loss to the buyer of an option can be no greater than the initial premium paid for the contract, regardless of the performance of the underlying stock. This allows an investor to control the amount of risk assumed. On the contrary, the seller of the option, in return for the premium received from the buyer, assumes the risk of being assigned if the contract is exercised.
The OIC is a non-profit association created to educate the investing public and brokers about the benefits and risks of exchange-traded options. Options are a versatile but complex product and that is why OIC conducts hundreds of seminars throughout the year, distributes thousands of videos and brochures, and maintains a Web site focused on options education. Please visit here for a comprehensive tutorial on Options Basics.
| Buy Calls or Puts |
 Buying Calls
If you think a stock is going to go up, you can buy calls.
Imagine it is May and XYZ is trading at $33 when you decide to buy 1 XYZ JUN 30 CALL for $4. If XYZ went up, so would your option. For example, if XYZ increased from $33 to $38, your call would also increase from $4 to perhaps $9. In both cases the asset has increased by $5, but that is an increase of 125% in the option and only 15% in the stock.
Conversely, if XYZ went below $30, the option would be out-of-the-money and its value would decline toward zero as it neared expiration, costing you 100% of your investment.
Buying Puts
If you are bearish on a stock, you might want to buy puts.
To illustrate put buying, imagine it is May and XYZ is trading at $33 when you buy 1 XYZ JUN 35 PUT for $3. As the price of XYZ declines, your put becomes more valuable. For example, if XYZ dropped from $33 to $30, your put would increase from $3 to around $6. In this case a 10% drop in the stock could cause a 100% increase in your put.
Conversely, if XYZ rallied and then stayed above the $35 strike price, your put would be out-of-the-money and decline in value as it neared expiration. Of course XYZ might also fluctuate wildly before expiration, giving you various opportunities to sell or exercise your put.
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| Covered writing (long stock, short call)* |
Covered Write
Writing covered calls is selling calls on stock you already own. Because you own the stock, you can use your stock position to fulfill the option in the event the call is exercised. In order to be a covered call you must own at least as many shares of the stock as the number of shares represented by the calls.
For example let's say you own 100 shares of XYZ and the stock was purchased at $38 per share. To complete the covered call, you could sell 1 XYZ June 40 call at $4. If the stock drops a little, the profit from selling your call will offset your loss on the long stock. If the stock moves to $35 on expiration, you will have lost $3 per share on the stock but made $4 (times 100) on the expired call. This leaves you with a net profit of $100 even though the stock went down.
If the stock rallies, then your call will be exercised and you will no longer have either the call or the stock. You will be forced to sell the stock at $40 per share. However, since you also sold the call at $4 you would get to keep this premium. This would be the equivalent of selling the stock at $44 per share (the $40 strike plus the $4 premium).
As the example illustrates, covered writes may be a useful way of obtaining additional profit from a long stock position with minimal risk. |
| Spreads & Straddles** |
 Bull Spread Example
Because the profit and loss from the two calls are used to offset one another, the most you can ever lose with a bull spread is the cost of the spread itself, in this example $2. In addition, the most you can ever gain from a bull spread is the difference between the two strike prices less the cost of the spread, in this case $3 (35 - 30 - 2).
Note that a bull spread reaches its maximum loss when the stock is below the lower strike price, and its maximum profit when the stock is above the higher strike price.
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Uncovered Call & Put writing
(also known as Selling options to open)*** |
Selling Calls
Call selling is one way to take advantage of a declining stock.
Imagine that XYZ is trading at $38 when you sell 1 XYZ JUN 35 CALL for $5 on a bearish expectation.
If your expectation proves to be correct and XYZ drops below the $35 strike price, the option will never be exercised and you will retain the entire premium. However, if you are wrong and XYZ remains above the strike price, the option will be exercised and you will be required to sell 100 shares of XYZ to the option buyer at $35.
Because there is no limit to how high a stock can trade, when you sell calls and do not also own the stock, you expose yourself to the possibility of unlimited loss.
Selling Puts
Selling puts is a bullish position.
For example, if XYZ was trading for $32 and you expected XYZ to go up, you might sell 1 XYZ JUN 35 PUT for $5. As long as XYZ traded at or above the $35 strike price, the put would not be exercised and you would keep the $5 premium.
However, IF XYZ dropped below $35, the put would be in-the-money and would be exercised. As the option seller you would be assigned, forcing you to purchase 100 shares of XYZ at $35.
Furthermore, if XYZ was trading at $26 when the option expired, it would be exercised, and you would lose $4 per-share: the $26 market value of the stock, minus the $35 strike price, plus the $5 you received for selling the put. |
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