Understanding Options (part 2) – Buying Puts And Calls

Last week I discussed the basics of options in my post Options Are Complicated For A Reason. I listed the most important terms and displayed an option matrix that explains the basic concepts of calls and puts in a visual manner. Now that you understand some of the core concepts of options, it\’s time for step 2 – buying calls and puts.

RECAP

A call option gives you the RIGHT to buy a stock as the holder of the option. If the buyer has the RIGHT, then naturally, the seller has the OBLIGATION to deliver the stock to the buyer.

In terms of put options, the owner of the contract has the RIGHT to sell a stock and the seller of that option has the OBLIGATION to buy that stock from the option holder.

The easiest way to conceptualize your right/obligation as a buyer/seller is to always think about the trade from the perspective of the holder/buyer. If the holder has the RIGHT to do one thing, the seller of that option must always deliver what is required of the contract. When dealing with spreads, the obligations can get complicated very quickly. This will help simplify the responsibilities of each party.

TRADING STRATEGIES

When investing in any security, you must have a goal in mind.  For example, your intent could a conservative hedging strategy, steady growth or an all out speculative strategy where you don\’t mind losing your principle for the potential of a large payout. Buying calls and puts span two of these investment goals – insurance and speculation (high risk). Both strategies involve going long (buying), but the intentions differ vastly.

Insurance

I\’ll start with the insurance trade since it\’s the more conservative of the two.  This trade involves purchasing options to insure or hedge against a position already in your portfolio. Much like an insurance policy on your car gives you the right to receive compensation for your totaled vehicle, options grant you the same type of protection.  The insurance company doesn\’t actually take possession of your car when you\’re paid out, but the concept is the same.

We established earlier that a put gives the holder the option to sell a stock at the strike price; therefore, you would buy a put to insure against a long position.  On the other hand, if you want to insure against a short position, you would buy a call option as a call gives you the right to buy a stock at the strike price (covering your short).  The latter is not used that often as short positions are in nature, short term trades. Usually, it doesn\’t make sense to insure your short trade.

• Example: You own ABC stock at $50.  To insure your position and guarantee that you can sell your stock at $45, you would buy one put contract with a strike price of $45 for every 100 shares you own.  The length of the contract is up to you, but keep in mind, you\’ll pay a higher premium as the duration increases. 

Speculation

Most of the contracts that you see traded are speculative trades. You are purely betting on the movement of the stock one way or another.

A bullish strategy is to buy a call when your think a stock price will increase and a bearish strategy is purchasing a put when you\’re betting that a stock price will decrease. The speculative trade is risky because you are limited by the life of the option. Unlike a stock, you can\’t hold the option contract forever. If the stock does not move in the direction you are betting on by expiration, your option position will most likely be worthless.  Before expiration, there is a chance that you could sell your option for it\’s time value, but you will still lose money.

When buying a call or put for speculative reasons, your max loss is the amount invested, but your max gains are substantial.  Long calls have unlimited upside potential because a stock can go up an infinite amount and the max gain of a put option will cap when the stock reaches a price of 0.  This is worth charting.

The purple line in both charts represent the price of the stock.  You can see that as the price rises or falls in the respective charts, the option increases in value as shown by the green line.  The difference between the two lines is the premium paid for the option contract.

• Call option example:  ABC is trading at $50 and you purchase a call option with a $55 strike price for a cost of $1. You are bullish ABC and you now own the right to buy ABC at $55.  If ABC rises to a price of $60, your option is worth $5 ($60 – $55).  You paid a premium of $1 so your profit is $4.  As the price continues to rise, your profit grows along with it.

Options are not suitable for everybody, but everybody involved in the market must understand what they are.  The price of an option is of course affected by the security it derives its value from, but the reverse can also be true.  If a stock\’s options have a higher than normal ratio to one another, they could actually drive the stock price up or down.

Another feature of options is the potential of high returns on a small amount of capital. It\’s not unheard of to take a speculative position and earn multiple times your money over a few days where as the underlying stock may only move a couple percentage points.

Readers:  Who has had successes or failures trading options? How do you feel about the insurance vs. speculation trading strategies?