| Maximum Gain | Maximum Loss | |
|---|---|---|
| Call Buyer | Unlimited | Premium |
| Put Buyer | Limited | Premium |
Using Long Calls
As the name indicates, going long on a call involves buying call options, betting that the price of the underlying asset will increase with time.
For example, suppose a trader purchases a contract with 100 call options for a stock that’s currently trading at $10. Each option is priced at $2. Therefore, the total investment in the contract is $200. The trader will recoup her costs when the stock’s price reaches $12.
Thereafter, the stock’s gains are profits for her. There are no upper bounds on the stock’s price, and it can go all the way up to $100,000 or even further. A $1 increase in the stock’s price doubles the trader’s profits because each option is worth $2.
Therefore, a long call promises unlimited gains. If the stock goes in the opposite price direction (i.e., its price goes down instead of up), then the options expire worthless and the trader loses only $200. Long calls are useful strategies for investors when they are reasonably certain that a given stock’s price will increase.
Writing Covered Calls
In a short call, the trader is on the opposite side of the trade (i.e., they sell a call option as opposed to buying one), betting that the price of a stock will decrease in a certain time frame.
But writing a naked call—without owning actual stock—can also mean unlimited losses for the trader because, if the price doesn’t go in the planned direction, then they would have to spend a considerable sum to purchase and deliver the stock at inflated prices.
A covered call limits their losses. In a covered call, the trader already owns the underlying asset. Therefore, they don’t need to purchase the asset if its price goes in the opposite direction. Thus, a covered call limits losses and gains because the maximum profit is limited to the amount of premiums collected.
Covered calls writers can buy back the options when they are close to in the money. Experienced traders use covered calls to generate income from their stock holdings and balance out tax gains made from other trades.
Long Puts
A long put is similar to a long call except that the trader will buy puts, betting that the underlying stock’s price will decrease. Suppose a trader purchases a one 10-strike put option (representing the right to sell 100 shares at $10) for a stock trading at $20.
Each option is priced at a premium of $2. Therefore, the total investment in the contract is $200. The trader will recoup those costs when the stock’s price falls to $8 ($10 strike – $2 premium).
Thereafter, the stock’s losses mean profits for the trader. But these profits are capped because the stock’s price cannot fall below zero. The losses are also capped because the trader can let the options expire worthless if prices move in the opposite direction.
Therefore, the maximum losses that the trader will experience are limited to the premium amounts paid. Long puts are useful for investors when they are reasonably certain that a stock’s price will move in their desired direction.
Short Puts
In a short put, the trader will write an option betting on a price increase and sell it to buyers. In this case, the maximum gains for a trader are limited to the premium amount collected. However, the maximum losses can be unlimited because she will have to buy the underlying asset to fulfill her obligations if buyers decide to exercise their option.
Despite the prospect of unlimited losses, a short put can be a useful strategy if the trader is reasonably certain that the price will increase. The trader can buy back the option when its price is close to being in the money and generates income through the premium collected.
Combinations
The simplest options position is a long call (or put) by itself. This position profits if the price of the underlying rises (falls), and your downside is limited to the loss of the option premium spent.
If you simultaneously buy a call and put option with the same strike and expiration, you’ve created a straddle. This position pays off if the underlying price rises or falls dramatically; however, if the price remains relatively stable, you lose the premium on both the call and the put. You would enter this strategy if you expect a large move in the stock but are not sure in which direction.
Basically, you need the stock to move outside of a range. A similar strategy betting on an outsized move in the securities when you expect high volatility (uncertainty) is to buy a call and buy a put with different strikes and the same expiration—known as a strangle. A strangle requires larger price moves in either direction to profit but is also less expensive than a straddle.
On the other hand, being short a straddle or a strangle (selling both options) would profit from a market that doesn’t move much.
Spreads
Spreads use two or more options positions of the same class. They combine having a market opinion (speculation) with limiting losses (hedging). Spreads often limit potential upside as well. Yet these strategies can still be desirable since they usually cost less when compared with a single options leg. There are many types of spreads and variations on each. Here, we just discuss some of the basics.
Vertical spreads involve selling one option to buy another. Generally, the second option is the same type and same expiration but a different strike. A bull call spread, or bull call vertical spread, is created by buying a call and simultaneously selling another call with a higher strike price and the same expiration.
The spread is profitable if the underlying asset increases in price, but the upside is limited due to the short-call strike. The benefit, however, is that selling the higher strike call reduces the cost of buying the lower one.
Similarly, a bear put spread, or bear put vertical spread, involves buying a put and selling a second put with a lower strike and the same expiration. If you buy and sell options with different expirations, it is known as a calendar spread or time spread.
A butterfly spread consists of options at three strikes, equally spaced apart, wherein all options are of the same type (either all calls or all puts) and have the same expiration. In a long butterfly, the middle strike option is sold and the outside strikes are bought in a ratio of 1:2:1 (buy one, sell two, buy one).
If this ratio does not hold, it is no longer a butterfly. The outside strikes are commonly referred to as the wings of the butterfly, and the inside strike as the body. The value of a butterfly can never fall below zero. Closely related to the butterfly is the condor—the difference is that the middle options are not at the same strike price.
Synthetics
Combinations are trades constructed with both a call and a put. There is a special type of combination known as a synthetic. The point of a synthetic is to create an options position that behaves like an underlying asset but without actually controlling the asset.
Why not just buy the stock? Maybe some legal or regulatory reason restricts you from owning it. But you may be allowed to create a synthetic position using options. For instance, if you buy an equal amount of calls as you sell puts at the same strike and expiration, you have created a synthetic long position in the underlying.
Boxes are another example of using options in this way to create a synthetic loan, an options spread that effectively behaves like a zero-coupon bond until it expires.
What Does Exercising an Option Mean?
Exercising an option means executing the contract and buying or selling the underlying asset at the stated price.
Is Trading Options Better than Stocks?
Options trading is often used to hedge stock positions, but traders can also use options to speculate on price movements. For example, a trader might hedge an existing bet made on the price increase of an underlying security by purchasing put options. However, options contracts, especially short options positions, carry different risks than stocks and so are often intended for more experienced traders.
What Is the Difference Between American Options and European Options?
American options can be exercised anytime before expiration, but European options can be exercised only at the stated expiry date.
How Is Risk Measured with Options?
The risk content of options is measured using four different dimensions known as the “Greeks.” These include the delta, theta, gamma, and vega.
How Are Options Taxed?
Call and put options are generally taxed based on their holding duration. They incur capital gains taxes. Beyond that, the specifics of taxed options depend on their holding period and whether they are naked or covered.
The Bottom Line
Options do not have to be difficult to understand when you grasp their basic concepts. Options can provide opportunities when used correctly and can be harmful when used incorrectly. If you’re new to the options world, take your time to understand the intricacies and practice before putting down serious money.
Correction—Oct. 24, 2024: This article has been corrected to state that writing a naked call—without owning actual stock—could lead to unlimited losses for a trader.
