Uses of Options
The first lesson covered what options are, but perhaps you are still not quite sure how you can use them. The next few screens will describe the Core Options Strategies; when they are used and how they can enhance your investment choices.
In order to understand the fundamentals of options, you need to learn the basics of Calls and Puts. In this section, you will be taught:
How rights and obligations are involved with options?
What it means to have a long or short position?
The Core Options Strategies: Long Call, Protective Equity Puts,Buying Put Options, and Covered Call Selling.
The first lesson covered what options are, but perhaps you are still not quite sure how you can use them. The next few screens will describe the Core Options Strategies; when they are used and how they can enhance your investment choices.
In order to understand the fundamentals of options, you need to learn the basics of Calls and Puts. In this section, you will be taught:
How rights and obligations are involved with options?
What it means to have a long or short position?
The Core Options Strategies: Long Call, Protective Equity Puts,Buying Put Options, and Covered Call Selling.
The first lesson covered what options are, but perhaps you are still not quite sure how you can use them. The next few screens will describe the Core Options Strategies; when they are used and how they can enhance your investment choices.
Rights Vs. Obligations
Remember that a Call Option gives its owner the right, but not the obligation, to buy stock at a certain price and before a certain date.
A Put Option gives its owner the right, but not the obligation, to sell stock at a certain price and before a certain date.
Also, recall that options sellers (writers) are obligated to sell or buy the underlying security, depending if they have sold Calls or Puts, respectively.
In this sense, writers of options are like insurance companies, and those that take on too much risk can expose themselves to substantial losses. In this section, we will cover how to write options responsibly.
Long and Short Positions-Calls
You were taught earlier that Call owners (buyers) have the right to buy stock if they exercise their options. Call writers (sellers), on the other hand, have the obligation to sell that stock to the owner, if they are assigned to.
When investors open a position by buying Calls, they are long those options. When investors open a position by selling Calls, they are short those options.
To close the positions, the buyer could sell his long Calls back in the marketplace, and the seller could buy the short Calls back in the marketplace.
Another way to remember the difference between long and short option positions is if you are long options, you have the right to exercise; if you are short options, you have the obligation of assignment.
Long and Short Positions-Puts
Put Positions are different from Call positions in that the owner has the right to sell, not buy, the underlying security.
When investors open a position by buying Puts, they are long those options. When investors open a position by selling Puts, they are short those options.
Once again, if you are long options, you have the right to exercise; if you are short options, you have the obligation of assignment.
You can, however, always close either position in the marketplace, by simply selling if long and buying back if short.
Using Equity Calls
Remember, in lesson 1 we were following XYZ , which was at $29 a share, and chose to buy an XYZ May 30 Call for 2, instead of buying the stock outright.
This option gave us the right to buy 100 shares of XYZ Stock at $30 a share any time before May expiration. For this right, we paid $200.
NOTE: Remember, most prices need to be multiplied by 100, since options are usually for 100 shares.
Values of the Call
On expiration Friday, XYZ was at $35 per share. We had our Call option, which we could have exercised to purchase 100 shares of XYZ Stock at $30 per share.
We could then sell that stock back in the market and make a $5 return per share, or $500. Since our initial Call premium was $200, our net profit is $300.
We could also have kept the stock, or, we could have simply sold the option back in the market.
NOTE: Most options are never exercised; holders choose to take their profits simply by trading out of the options.
If we had been wrong about XYZ and it had gone down to $10 a share, our only loss would be the premium amount we paid for the Call - $200 ($2 per share), since the option would be worthless.
Using Protective Equity Puts
In our other example, we had bought some XYZ at a price of $31 a share, and it was trading up at $32 a share.
But, we were concerned that an adverse market move might have caused our investment in XYZ to lose money, so we bought an XYZ Aug 30 Put for 1.
This gave us the right to sell our stock at a price of $30 a share in the event it had gone down in value. Since we owned 100 shares, and each option is for 100 shares, we bought one Put, and for this, we paid $100.
Values of the Protective Puts
We bought the XYZ Aug 30 Put, which gave us the right to sell our stock at $30 a share, no matter how low it went.
Protective Puts act like an insurance policy on our stock, and protect us against losses below $30 a share.
We did not have to exercise the Put, since we were the holder and had the choice.
Buying a Put Option
We've looked at how to use Calls if you're bullish on a stock, and how to use Protective Puts if you're bullish, but nervous, on a stock you already own.
But suppose you have an opinion that a stock is going to fall in price. Is there a way to take advantage of that outlook using options? Well, yes.
Remember that Puts are options to sell at a fixed price, and, as such, they increase in value as a stock price falls. Therefore, if you just buy Puts, not Protective Puts where you own the underlying stock, you can potentially profit from down moves in a stock.
Take a look at XYZ again, at $31 a share. Assume you are bearish on this stock, and think that it will fall to, say, at least $27 by August option expiration.
You could take advantage of this outlook by purchasing an XYZ Aug 30 Put by itself for 1 ($100). If the stock falls, you can profit from the increase in the value of the Put.
Assume you turn out to be right, and at expiration XYZ is at $25. Since you bought the XYZ Aug 30 Put, you own the right to sell XYZ stock to someone at a fixed price of $30 a share. This option is now worth something.
In fact, at expiration, it is worth $5 ($500). Since you paid $1 for it, you earned $4 profit per share, or $400. And you never had to take a position, like a short sale, in the underlying stock.
Selling a Covered Call
Let's do one more strategy. We've looked at how to use options if you're bullish on a stock, and how to use Puts if you're bearish on a stock.
But what if you're neutral on a stock, meaning you think it will remain relatively unchanged?
This can be especially aggravating if it's a stock you own. However, there is a way to potentially profit from this; it's called Covered Call Selling.
Now, when you sell a Call "Covered," what that means is that you already own the underlying stock. So, if the stock goes up in price, past the Call strike and the buyer of the Call exercises their option, you have to deliver the stock in your possession, but that's it.
If you sell a Call "Uncovered," that is to say, without owning the underlying stock, that exposes you to unlimited risk.
Assume that you are long 100 shares of XYZ currently at $29 a share, and you think that, for whatever reason (expected earnings, market slowdown, etc.) this stock is going to remain relatively unchanged through May expiration. You could sell one XYZ May 30 Call for 1.75.
This means that you get an immediate cash credit of $175.00, with the obligation that if the stock goes up past 30 and the holder exercises the Call, you will deliver your stock at $30 a share.
If this happens, since you sold the Call for 1.75 and would sell the stock for $1 over its present price of $29, you stand to earn a maximum profit of 2.75 if the stock increases past 30.
However, if the stock stands still, remaining at $29 at May expiration, you get to keep the $175.00. That is Covered Call Selling.
NOTE: If the stock price falls, you are still a stock owner, and are subject to the full loss of your stock investment, reduced only by the $175 credit from the sale of the Call. Covered Call Selling is not a protective strategy. Also, keep in mind writing an option on a stock with a low cost basis, there are tax consequences to consider upon assignment.
Rights Vs. Obligations
Remember that a Call Option gives its owner the right, but not the obligation, to buy stock at a certain price and before a certain date.
A Put Option gives its owner the right, but not the obligation, to sell stock at a certain price and before a certain date.
Also, recall that options sellers (writers) are obligated to sell or buy the underlying security, depending if they have sold Calls or Puts, respectively.
In this sense, writers of options are like insurance companies, and those that take on too much risk can expose themselves to substantial losses. In this section, we will cover how to write options responsibly.
Long and Short Positions-Calls
You were taught earlier that Call owners (buyers) have the right to buy stock if they exercise their options. Call writers (sellers), on the other hand, have the obligation to sell that stock to the owner, if they are assigned to.
When investors open a position by buying Calls, they are long those options. When investors open a position by selling Calls, they are short those options.
To close the positions, the buyer could sell his long Calls back in the marketplace, and the seller could buy the short Calls back in the marketplace.
Another way to remember the difference between long and short option positions is if you are long options, you have the right to exercise; if you are short options, you have the obligation of assignment.
Long and Short Positions-Puts
Put Positions are different from Call positions in that the owner has the right to sell, not buy, the underlying security.
When investors open a position by buying Puts, they are long those options. When investors open a position by selling Puts, they are short those options.
Once again, if you are long options, you have the right to exercise; if you are short options, you have the obligation of assignment.
You can, however, always close either position in the marketplace, by simply selling if long and buying back if short.
Using Equity Calls
Remember, in lesson 1 we were following XYZ , which was at $29 a share, and chose to buy an XYZ May 30 Call for 2, instead of buying the stock outright.
This option gave us the right to buy 100 shares of XYZ Stock at $30 a share any time before May expiration. For this right, we paid $200.
NOTE: Remember, most prices need to be multiplied by 100, since options are usually for 100 shares.
Values of the Call
On expiration Friday, XYZ was at $35 per share. We had our Call option, which we could have exercised to purchase 100 shares of XYZ Stock at $30 per share.
We could then sell that stock back in the market and make a $5 return per share, or $500. Since our initial Call premium was $200, our net profit is $300.
We could also have kept the stock, or, we could have simply sold the option back in the market.
NOTE: Most options are never exercised; holders choose to take their profits simply by trading out of the options.
If we had been wrong about XYZ and it had gone down to $10 a share, our only loss would be the premium amount we paid for the Call - $200 ($2 per share), since the option would be worthless.
Using Protective Equity Puts
In our other example, we had bought some XYZ at a price of $31 a share, and it was trading up at $32 a share.
But, we were concerned that an adverse market move might have caused our investment in XYZ to lose money, so we bought an XYZ Aug 30 Put for 1.
This gave us the right to sell our stock at a price of $30 a share in the event it had gone down in value. Since we owned 100 shares, and each option is for 100 shares, we bought one Put, and for this, we paid $100.
Values of the Protective Puts
We bought the XYZ Aug 30 Put, which gave us the right to sell our stock at $30 a share, no matter how low it went.
Protective Puts act like an insurance policy on our stock, and protect us against losses below $30 a share.
We did not have to exercise the Put, since we were the holder and had the choice.
Buying a Put Option
We've looked at how to use Calls if you're bullish on a stock, and how to use Protective Puts if you're bullish, but nervous, on a stock you already own.
But suppose you have an opinion that a stock is going to fall in price. Is there a way to take advantage of that outlook using options? Well, yes.
Remember that Puts are options to sell at a fixed price, and, as such, they increase in value as a stock price falls. Therefore, if you just buy Puts, not Protective Puts where you own the underlying stock, you can potentially profit from down moves in a stock.
Take a look at XYZ again, at $31 a share. Assume you are bearish on this stock, and think that it will fall to, say, at least $27 by August option expiration.
You could take advantage of this outlook by purchasing an XYZ Aug 30 Put by itself for 1 ($100). If the stock falls, you can profit from the increase in the value of the Put.
Assume you turn out to be right, and at expiration XYZ is at $25. Since you bought the XYZ Aug 30 Put, you own the right to sell XYZ stock to someone at a fixed price of $30 a share. This option is now worth something.
In fact, at expiration, it is worth $5 ($500). Since you paid $1 for it, you earned $4 profit per share, or $400. And you never had to take a position, like a short sale, in the underlying stock.
Selling a Covered Call
Let's do one more strategy. We've looked at how to use options if you're bullish on a stock, and how to use Puts if you're bearish on a stock.
But what if you're neutral on a stock, meaning you think it will remain relatively unchanged?
This can be especially aggravating if it's a stock you own. However, there is a way to potentially profit from this; it's called Covered Call Selling.
Now, when you sell a Call "Covered," what that means is that you already own the underlying stock. So, if the stock goes up in price, past the Call strike and the buyer of the Call exercises their option, you have to deliver the stock in your possession, but that's it.
If you sell a Call "Uncovered," that is to say, without owning the underlying stock, that exposes you to unlimited risk.
Assume that you are long 100 shares of XYZ currently at $29 a share, and you think that, for whatever reason (expected earnings, market slowdown, etc.) this stock is going to remain relatively unchanged through May expiration. You could sell one XYZ May 30 Call for 1.75.
This means that you get an immediate cash credit of $175.00, with the obligation that if the stock goes up past 30 and the holder exercises the Call, you will deliver your stock at $30 a share.
If this happens, since you sold the Call for 1.75 and would sell the stock for $1 over its present price of $29, you stand to earn a maximum profit of 2.75 if the stock increases past 30.
However, if the stock stands still, remaining at $29 at May expiration, you get to keep the $175.00. That is Covered Call Selling.
NOTE: If the stock price falls, you are still a stock owner, and are subject to the full loss of your stock investment, reduced only by the $175 credit from the sale of the Call. Covered Call Selling is not a protective strategy. Also, keep in mind writing an option on a stock with a low cost basis, there are tax consequences to consider upon assignment.
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