Introduction to options trading: What are calls and puts, and how to use them?
In all honesty, if you're here to learn about options, it may be best to just stay away. But since we all have a 3rd grader's reading comprehension here, I know that warning didn't mean much to you. So in my attempt to prevent some sleepless nights, I will explain options to you like a 2nd grader. Hopefully, giving you a basic understanding can save you some capital losses and antidepressant prescriptions. So sit down and learn how to avoid losing your net worth in a matter of weeks.
What is an option?
In simple terms, an option is a contract that gives you the right or obligation to buy or sell a stock at a specific price and date. That price is referred to as the strike price, and the date is the expiration date. To obtain an option, you pay a cost called a premium. Option premiums vary depending on how close the underlying stock's price is to the strike price and how far away the expiration date is. To spare you the complexities of option pricing, we'll save that topic for another article.
Why trade options?
As you may have heard, options are complex instruments that require a deep understanding and due diligence. But let's be real, we want to trade options because we're degenerates looking for hockey stick returns in a matter of days. The reality for those of us here is we'll never outsmart the army of brilliant Chinese quants employed by Citadel and friends. Nonetheless, knowing how to properly trade calls and puts can prevent premature bankruptcy… and even make us money.
So, why do people trade options? Well, for starters, they offer leverage. Each option contract gives you the right to capture the upside or downside of 100 shares of the underlying stock without having to buy 100 shares. You can control a lot of shares for the price of the premium, which means you can make a lot of money when you're directionally right about which way the stock moves. You can also use options to generate income on stocks you hold or protect against downside risk.
What are calls and puts?
Before we get into the meat and potatoes, let's talk about what calls and puts are at a high level. In simple terms, a call option is a contract that gives the holder the right, but not the obligation, to buy a stock at a specific price and date. A put option, on the other hand, is a contract that gives the holder the right, but not the obligation, to sell a stock at a specific price and date.
Buying and selling calls
Now, let's talk about the fun stuff, buying and selling options. For those starting out, I recommend sticking with calls because they are safer and more intuitive than puts.
Buying call options
Buying a call option means you believe the stock is going to go up. If you're right, you can sell the option for a profit or exercise the option and buy 100 shares of the underlying stock at the lower strike price. If you're wrong and the stock price falls below your strike price, then your option expires, and you lose the premium you paid for that call.
Selling call options
If you have 100 shares of an underlying stock, you can sell a call option to collect a premium. Selling calls is a good way to generate income on your existing stocks, but it does limit your upside potential. For example, if the stock price goes above your strike price, you miss out on all the additional gains. You should only sell calls at a price you won't regret selling your shares for.
Note, you should always own 100 shares of the underlying stock before selling calls. NEVER, EVER, EVER sell naked calls, which are calls without the backing of the underlying stock; losses on naked calls can be infinite.
Buying and selling puts
Although puts are inversely similar to calls, most people have a harder time grasping the concept. Call options are used more widely, but puts have their purpose as well.
Buying put options
Buying a put option means you believe the stock is going to go down, so you pay a premium to buy the rights to sell 100 shares of the underlying stock at the strike price. If you're right, you can sell the put option for a profit or exercise the option and sell 100 shares of the underlying stock at the higher strike price. If you're wrong and the stock price goes above your strike price, then your option expires, and you lose the premium you paid for that put.
Selling put options
Selling puts is quite the degenerate move because you're collecting a premium to hold the bag if prices fall. You should only sell puts if the market thinks a stock's price will fall, but you are ok with owning 100 shares of the stock at the strike price because of long-term potential. Still pretty stupid in my opinion.
If you sell a put, and the stock's price falls below the strike price, you will still have to buy 100 shares at the higher price. Your upside is limited to the premium you collect, but your downside could be the full value of 100 shares. When selling puts, your brokerage will likely hold the full value of 100 shares of a stock per option as collateral, so your money is locked up until expiration.
Between the limited upside and having your money locked up, just avoid selling puts.
The calls and puts table
To summarize how to utilize calls and puts, here's a simple table to keep in mind.
You Think Prices Will…
Buy or Sell
Options are dangerous. This article is a quick guide to understanding the basics of calls and puts, but I implore you to conduct more research. Remember, options should only be a small part of your investments. You may think you're Warren Buffet with a money printer after a few hits, but the imminent implosion is just one bad trade away.
Be smart and let's make some tendies!