Options may seem like an incredibly complicated investment tool. And certainly, if you're not careful with them, you can put yourself in a situation with options where you could lose more than 100% of your invested capital. Despite that risk, they're actually rather straightforward, with only four basic types of investments involved. Where they get complicated is when you combine multiple options contracts together into what are known as multilegged positions.
In their standard form, options come in two flavors: puts and calls. As an options investor, you can open an options position by either buying or selling either kind of option. That makes buying calls, selling calls, buying puts, or selling puts those four basic options investments.
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Options fundamentals
When it comes to options on stocks, a typical options contract involves the right to buy or sell 100 shares of the underlying stock. Call options are contracts involving the right to buy those shares, while put options are contracts involving the right to sell those shares .
In addition to the information on the underlying stock itself, key parts of an options contract include the strike price and expiration date of the contract. The strike price is the price at which the options contract executes, and the expiration date is the last date at which the owner of the contract can execute it.
A typical call options contract gives the buyer the right to buy 100 shares of the stock at the strike price on or before that expiration date. A typical put options contract gives the buyer the right to sell 100 shares of the stock at the strike price on or before that expiration date. To purchase those rights, the buyer pays a premium to the seller. In return for receiving that up-front premium, the seller accepts the obligation to deliver the other end of the contract.
Using the same example as above, a call option contract obligates the seller to sell 100 shares of the stock to the buyer at the strike price on or before the expiration date. A put contract obliges the seller to buy 100 shares of the stock from the buyer at the strike price on before the expiration date.
In addition, both buyers and sellers generally have to pay commissions and Securities and Exchange Commission fees and will likely face friction costs from bid/ask spreads as well. For the sake of keeping the discussion somewhat simplified, we'll ignore those commissions, fees, and spread costs for the rest of this article, but recognize that they are a real cost of investing in options.
The premium the buyer pays to the seller consists of two parts: an intrinsic value part and a time value part. The intrinsic value part is based on how far above the strike price the option is if it's a call option or how far below the strike price the option is if it's a put option. The time value part is based on several different factors, one of the most important of which is the time remaining until the option expires. All else being equal, the longer the time period before expiration, the higher that time value will be.
Premiums are generally quoted on a per share basis. In other words, if the contract on 100 shares at a $50 per share strike price is priced at $3, the buyer would pay $300 to open the contract, and the seller would receive that same $300. Options are generally nowhere near as liquid as stocks are, so be certain to use a limit order whenever buying or selling them.
Buying calls (long call position)
When you buy a call option on stocks, you pay for the right to buy shares of that company's stock at a certain price on or before a certain date. This is generally considered a bullish strategy, because you make money if the stock goes up. On that front, if the stock rises above the strike price by more than the premium you paid to buy it, your profit would start to be magnified versus what you'd get simply from owning the stock.
On the flip side, if the stock closes at or below its strike price on expiration day, you will lose 100% of your investment in the option. The chart below shows your potential profit at expiration for a long call position. It assumes a single contract on 100 shares with a $3 per share premium and a $50 strike price.
Selling calls (short call position)
When you sell a call option on stocks, you get paid to pick up the obligation to sell shares of that company's stock at a certain price on or before a certain date. This is generally considered a bearish strategy because you make money if the stock stays stagnant or drops. On that front, if the stock closes at or below the strike price at expiration, you can book 100% of the premium you received (less commissions and fees) as profit.
On the flip side, you face a potentially unlimited loss when selling calls, as the stock could potentially skyrocket to any price prior to expiration. This is a key reason why many options investors only sell calls short if they're covered by another position, such as owning the underlying stock or a different long call position on the same stock. The chart below shows your profit at expiration for a short call position. It assumes a single contract on 100 shares with a $3 per share premium price and a $50 strike price.
Buying puts (long put position)
When you buy a put option on stocks, you pay for the right to sell shares of that company's stock at a certain price on or before a certain date. This is generally considered a bearish strategy, because you make money if the stock goes down. On that front, many people purchase puts as an insurance policy against their stocks dropping. The theory is that if they own puts that rise at the same time that their stocks fall, their portfolio will remain closer to flat overall.
On the flip side, if the stock closes at or above its strike price on expiration day, you will lose 100% of your investment in the option. The chart below shows your profit at expiration for a long put position. It assumes a single contract on 100 shares with a $3 per share premium and a $50 strike price.
The fact that your losses are limited if the stock rises substantially is part of what makes long put positions a potentially tempting insurance-like position. After all, it means you may still be able to participate in any rally that occurs, although your net gains would be reduced by the premium you paid to buy the options.
Selling puts (short put position)
On the flip side, when you sell a put option on stocks, you get paid to take on the obligation to buy shares of that company's stock at a certain price on or before a certain date. This is generally considered a bullish strategy, as you profit if the company's share price remains stable or increases before expiration. On that front, if the stock closes at or above the strike price at expiration, you can book 100% of the premium you received (less commissions and fees) as profit.
You do lose money on the position if the stock's price falls, but unlike a short call position, your potential loss is considered limited, since share prices don't generally drop below $0. The chart below shows your profit at expiration for a short put position. It assumes a single contract on 100 shares with a $3 per share premium and a $50 strike price.
Options are frequently used in combinations
Although the four basic options investments you can make are fairly straightforward, they can be combined to create far more advanced positions. Those combinations are what many options investors use when managing their investments, as multilegged positions can help either manage or amplify the risk/reward profile.
Still, options are leveraged investments where you may have the potential to lose more than 100% of your invested capital if things don't go your way. That makes it crucially important to manage the size of your options risk when compared to your overall asset allocation plan. That way, if your options investments don't go the way you hope, your overall plan can remain on track, while if they do turn out in your favor, they can be the icing on your cake.
