Options Education - The Fundamentals
What are the "basic" option trades?
Though more advanced option traders love to spend their time talking about spreads, butterflies, strangles, naked calls and naked puts (actual things - not porn for option junkies!), collars, condors, and all sorts of other fun and exciting strategies that can be employed when trading options, it is important to gain a basic understanding how options work in their simplest form before tackling some of those more advanced strategies.
The following four actions represent the most common "first option trades" that investors new to options trading often make:
Buying Calls
What it is: Buying a call gives the holder of the contract the right to purchase 100 shares of stock at a certain price on or before a certain date.
When to use: Investors would execute this strategy if they were bullish and felt that a stock going to move up towards (and hopefully past) the strike price before the expiration date.
How money can be made: money is made if the stock rises quickly enough.
How money can be lost: as time goes by, the option loses time value (shorter duration = shorter time premium); if the option is below the strike price at expiration, it results in a 100% loss of capital.
Potential risk: limited to 100% of investment.
Potential reward: unlimited.
Buying Puts
What it is: Buying a put gives the holder of the contract the right to sell 100 shares of a stock at a certain price on or before a certain date.
When to use: Investors would execute this strategy if they were bearish and felt that a stock going to move down towards (and hopefully past) the strike price before the expiration date.
How money can be made: money is made if the stock falls quickly enough.
How money can be lost: as time goes by, the option loses time value (shorter duration = shorter time premium); if the stock is above the strike price at expiration, it results in a 100% loss of capital.
Potential risk: limited to 100% of investment.
Potential reward: unlimited*
*in reality, the reward is bounded by the magnitude of the strike price itself, since no stock can fall below $0.
Selling (out-of-the-money covered) Calls
What it is: selling a call obligates the writer of the contract to sell 100 shares of stock at a certain price if the holder of the contract exercises their right to buy on or before the expiration date.
When to use: Investors would execute this strategy if they were bullish enough on a stock to own it but bearish enough to think it was not likely to rise above the strike price before the expiration date.
How money can be made: money is made if the stock rises slowly (or not at all), thus causing the option to lose time value; if the stock is below the strike price at expiration, the option expires worthless and the seller keeps 100% of the premium received for writing the contract.
How money can be lost: the stock rises quickly; if the stock rises above the strike price, the seller of the contract may have their stock called away from them (thus resulting in a "missed opportunity" cost as the rally in the stock is missed out on).
Potential risk: limited to the losses that might be attained through depreciation in stock price (less the premium for writing the contract).
Potential reward: limited to the difference between the stock price and the strike price at the time the contract is written, plus the premium received for writing the contract.
Selling (out-of-the-money naked) Puts
What it is: selling a put obligates the writer of the contract to purchase 100 shares of stock at a certain price if the holder of the contract exercises their right to sell on or before the expiration date.
When to use: Investors would execute this strategy if they were interested buying a particular stock at a price lower than the market price but were not sure if the stock would ever drop below that price.
How money can be made: the stock stays above the strike price and the option loses value due to time decay; the stock is above the strike price at expiration, the seller keeps 100% of the premium received for writing the contract.
How money can be lost: money can be lost if the stock falls too quickly.
Potential risk: limited to the difference between the stock price and the strike price at the time of expiration (less the premium received for writing the contract).
Potential reward: limited to the premium received from the writing of the contract.
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