With options trading, buying options is the most straightforward route. The benefit of buying call and put options is that options amplify the underlying asset’s value so that the return can be many times more than the returns on an original stock. Another options trading strategy is to sell call and put options. Here, traders want the options they have sold to expire worthless so they can gain the premium paid for the option.
A call option allows you to buy a stock at a specific price in a specified time, while a put option enables you to sell at a particular price and within a specified period. One of the attractive features of call and put options is that their value can increase significantly with even small increases in stock price, allowing the holder (option owner) to make a substantial profit from a trade.
When buying or selling options, one of the main factors to consider is the implied volatility of the underlying asset. Volatility means a swing in price between the low and high prices. The higher the implied volatility, the higher the premium.
Buying Call and Put Options
In technical terms, buying a call means an investor has a long call position, and buying a put means the investor has a long put position. With both positions, the expectation is that movement in the price of the underlying asset will be sufficient to cover the premium and result in a profit as well.
Besides speculation, traders buy options to hedge their bets. To protect a long underlying position, they buy a protective put, also called a synthetic long call, because its risks/rewards match those of a long call. And, to ensure a short underlying position, they use a protective call (a synthetic long put).
To understanding buying options, let’s say that a stock priced at $50 has a call option with a strike price of 50 and costs $4. Believing that the price will increase before the expiration date, an investor may buy the call option for $400 (one option contract has 100 shares). Let’s say the price of the stock rises by $10 to $60. In this case, the investor will net a profit of $600 ($10 increase x 100 shares minus the $400 paid to buy the option). Also, notice that the return on investment is much higher for the option than the original stock.
Selling Call and Put Options
One thing to consider with selling options is whether the investor is covered or uncovered (naked). Covered means that the investor has a corresponding position in the underlying stock. Going covered or uncovered will directly affect the amount of risk associated with the trade.
Call Options: The term covered call is used for a trade in which you have a long position in the underlying asset. If the holder expects a flat or slightly bearish market, then writing an in the money covered call is a good option. For a mildly bullish expectation form the market, an out of the money covered call is the better option.
Another option is to sell uncovered calls. This high-risk strategy is used if the expectations are very bearish for the underlying asset. If the stock does trade over the strike price, the investor will have to buy the stock in the open market and then deliver that stock to the call owner at the agreed strike price. For this reason, uncovered calls have unlimited risk and should only be attempted by seasoned traders.
Put Options: With the covered put, an investor has a short position in the underlying asset. However, this strategy is rarely used, because there isn’t a lot of difference between the benefits of a naked call and a covered put. Also, naked calls make more sense because the premiums for call options are usually higher than put options, there is no need to pay dividends on the short stock, and the commission costs are higher with covered puts because you have to short the underlying asset and the option.
Uncovered puts are high risk and should be reserved for times when the expectation is very bullish for the underlying stock or when an investor wants to take a position in the stock but at a lower price.
For example, with a stock trading $100, an investor can sell a 90-strike price put for $2. If the stock trades below $90, the investor will be forced to buy the stock at that price. If the stock stays above $90, the $2 premium received for the sale is the put is the investors to keep.
This is why investors who want to buy stock sell downside naked puts, they either buy the stock for cheaper than the current price or they get paid a premium to keep to watch it trade higher, either way, it’s a win.
There are a lot of things to consider when deciding on whether to buy or sell options, just make sure you understand all the possible scenarios and know what strategy best first each given situation.