What You Need to Know About Call and Put Options
Becoming an experienced investor usually follows a certain path. You might have started by investing in mutual funds and progressed into opening up a brokerage account that lets you trade individual stocks. You’ve learned the basics of stock diversification and have no hesitation when it comes to placing stop and limit orders on stocks you’re trading. Now, you’re ready to take the next step.
Adding options trading to your investment strategy can help you boost returns, mitigate risk and hedge your positions. A stock option lets you leverage your money by controlling 100 shares of stock per contract. That means your potential gains or losses can be much higher than just trading stocks; you’ll need to be aware of the potentially increased volatility in your account. Unlike stocks, options have an expiration date, so timing your strategies well is extremely important. Used correctly, options can help you round out a portfolio and even reduce your exposure to risk.
Buying and Selling Call Options
A call option gives you the right, but not the obligation, to buy a stock at a specified price for a limited period of time. If the stock increases in value, you can exercise the option and make a profit. If the stock doesn’t increase in value, or even loses value, then you don’t have to do anything with the option. You can let it expire worthless and limit your loss to the cost of purchasing the call option.
Let’ take a look at how call options work.
Say you think XYZ stock will go higher in the next few months, but you don’t want to purchase 100 shares of stock. XYZ is currently trading at $50 per share and you decide to purchase a call option at $52.50 that expires in three months for $35. That means if the stock hits $52.85 or higher, you’ll make a profit. If the stock doesn’t hit this price within three months, you’ll lose the $35 it cost to buy the call.
You can also sell call options. Instead of having the option of buying a stock, you’re under the obligation to sell it. Selling a call without owning the stock is considered extremely high risk because there’s no limit to what kind of losses you might incur.
Let’s say you thought XYZ was going to go down instead of up, so you sell a call option and immediately make $35. As long as the stock doesn’t go higher than $52.85, you will end up with a $35 profit. However, if the stock rises higher than that, it will reduce your profit until you owe whatever the difference is. If the stock ended at $60, you would owe $750 minus the $35 you received when you sold the call.
Buying and Selling Put Options
A put option gives you the right, but not the obligation, to sell a stock at a specified price for a limited period of time. Buying a put means you believe a stock will decrease in value within a specified amount of time.
Let’s try buying a put instead of a call option.
XYZ stock is trading at $50 per share and you think it will go lower in the next three months. You purchase a put option at $48.50 that expires in three months for $35. If the stock drops below $48.15, you’ll make a profit. Otherwise, you’ll be limited to the loss of the put option – $35.
Selling a put option means you think the price of a stock could increase. You’ll be under the obligation to purchase 100 shares of stock at a specified price. Unlike selling call options, selling a put does limit how much risk you’ll be subject to, since a stock can only go down so far.
If you thought XYZ might go up, you might consider selling a put. Let’s say you sold a put at $50 on XYZ for $35. Like selling a call, you would immediately pocket the $35 gain. If XYZ then increases in value or holds at $50, the put would expire and you would keep the $35 gain. If the stock drops, though, you would be obligated to purchase 100 shares at $50 per share, regardless of what price the stock actually fell to.
By combining buying and selling both call and put options, you can set up unique strategies with their own risk/reward potential.
One of the most common strategies is known as a covered call, where you buy 100 shares of stock and then sell a call option at a higher price. That way you hedge against downside risk at the cost of limiting your total upside potential, since you would be obligated to sell the stock once it hit a specific price.
Once you get used to basic options strategies, you can begin utilizing more complex scenarios that can take your investment trading to the next level.