Reasonably Thinking

One of the tools I frequently use to execute my strategy is options.  Trading options enables various investment positions with differing amounts of money.  Now, everyday folks tend to shy away from options trading because it can be confusing, and if misused, can be very risky.  However, if used properly, options can supplement the investor’s toolkit.

Just like buying and selling stocks, buying and selling options is a tool.  Options offer greater tactical use than stocks since options allow for long, short, and neutral positions, as well as leveraging positions with varying degrees.  So let’s make this easy; being an introductory piece, I’ll stay away from pricing, “the Greeks” and strategies with fancy names.  I’ll just cover the basics here.

There are two types of options:  calls and puts.  A call option gives the investor the right (but not the obligation) to purchase a stock.  A put option gives the investor the right (but not the obligation) to sell a stock.  Each option has a strike price and expiration date.  The strike price is simply the price of the underlying share that the option is based on.  The expiration date is when the option contract expires.

(image from OptionsXpress)

Each option contract represents 100 shares of the underlying stock.  So, buying three call options allows the investor to buy 300 shares worth of stock (at a strike price for a given time period).  The same is true for puts; buying three put options allows an investor to sell 300 shares of stock.

Since there are two types of options (calls and puts), and each option can be bought or sold, four basic strategies can be produced.

Buy Call

Buying a call involves a small outlay of money (the premium) to purchase the option, which allows for participating in the upside movement of a stock.  If you think a stock is going to go up, this is a safe way to make a leveraged bet with limited downside.

Sell Call

On the other side of the trade, selling a call accepts the premium (cash now), but has unlimited risk if the stock increases.  Because this is very risky, most brokers restrict this activity unless you already own the underlying stock.

Buy Put

Buying a put is a bet that the stock will fall.  The investor pays a premium, and if the stock goes down, the investor is rewarded.  This is similar to purchasing insurance (accept you don’t have to own the stock).

Sell Put

Selling a put accepts the premium, but has downside exposure if the stock falls.

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Here are profit and loss graphs for the four basic strategies.  The Y-axis is Profit (greater than zero) and Loss (less than zero).  The X-axis is the price of the underlying stock.  For example, when an investor buys a call, he initially pays a premium (starts off at a small loss) and will make a profit if the stock increases (moving toward the right on the X-axis); if the stock falls (moving left on the X-axis), the investor only loses his initial premium.

(image from Investmentmoats.com)

If the investor is bullish on a stock, he can buy a call (buy the upside) or sell a put (sell the downside).

If the investor is bearish on a stock, he can sell a call (sell the upside) or buy a put (buy the downside).

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Bonus Material…

If an investor is bullish and very aggressive, he can sell a put and use the premium to buy a call.  This has the same profit/loss graph as buying a stock outright.  This is called a synthetic long.

(image from Investmentmoats.com)

The inverse of this is would be a bearish investor who sells a call to fund the purchase of a put.  This would have the same profit/loss graph as shorting a stock.  This is called a synthetic short.

(image from Investmentmoats.com)

Hopefully this gives folks some basic footing on how options work.  In the future, I intend to write a follow up article on how options can be used for income producing strategies (covered calls, cash secured puts), neutral strategies (straddles), and more directional bets (bull spreads, bear spreads).