Just mention options and even some of the most seasoned investors will have the same knee-jerk reaction: “They’re too complicated… too risky… too expensive.”
But this is just that — a knee-jerk reaction. In reality, if you know what you’re doing, options trades can be quite straightforward and open up a world of relatively safe alternatives to making money with stocks. In fact, options can even be a great deal more inexpensive than stocks… and deliver greater profits in a shorter time frame!
Options really shine when the markets are volatile. You can use them to leverage the movements of stocks or other tradable assets as they swing both up and down. And right now — with uncertainty rife in economies and governments all over the globe — is a perfect time to play the options game as the markets experience wild mood swings.
But what exactly are options… and how can you use them to your investing advantage? In this primer, we’re going to give you the basic rundown on what options investments are and how to place a very basic trade.
So What the Heck Are Options Anyway?
Here’s the best way to think of options: They’re bets on the future. Essentially, options are contracts that grant the right — but not the obligation — to buy or sell a stock on or by a certain date at a set strike price. They’re a type of financial instrument known as a derivative because options contracts derive their values from underlying assets. For this primer, we’re going to assume that the underlying assets are stocks.
And simply put, there are two basic forms of these contracts: call options and put options
Basic Forms of Options Contracts
We call the right to buy a stock a call option. These are bullish bets — you believe that the price of the underlying asset will rise by a specified time. With these options, money is made when the price of the underlying asset increases in value.
We call the right to sell a stock a put option, and it’s exactly the opposite of a call. These are bearish bets that the price of an asset will drop in value.
You purchase options via a contract. Each contract — be it a call or a put option — controls 100 shares.
Let’s explain each of these options contracts in more detail.
When You Think the Asset Is Going Up in Value — Use a Call Option
Believe it or not, popular e-commerce site Groupon gives us a great analogy for explaining how call options work. You open up your email and find a deal that gets you dinner for two at a super-fancy fixed-price restaurant for $100. This is such a deal — usually, you’d be looking at a $200 bill.
You buy the coupon for $100, and you must use it before it expires in 60 days. However, within two weeks of purchasing the coupon, the restaurant decides to raise its menu prices, and a dinner for two on the fixed-price menu now costs $225. You’ve realized a bit of profit here, since the restaurant is obliged to honor your coupon, for which you spent only $100.
When you buy a call option for a stock, you’re essentially doing the same thing. You’re buying the right to purchase shares of a company by a certain time in the future for a specific price.
An Example of a Call Option
Say you think that Apple, which is trading around $140 per share, is a great but undervalued stock and that it’s going to rise within a month, by June 1. You buy a call contract that states you have the right to buy 100 shares of Apple on or before June 1 (the contract’s expiration date) for $150 (the strike price).
Your instincts about the company are right, and by June 1, positive news has shares of Apple up to $200. At this point, you can exercise your option and receive 100 shares of the company for a steep discount; you would pay only $150 per share. Then you can sell them at the full price for an instant profit of $50 per share (minus the cost of the option and broker fees).
What if you were wrong? Well, if Apple shares actually drop to $120 during the month, you just let your contract expire and lose only the amount you spent to buy the call contract.
One of the advantages of an options contract is that the price to hold the options is much cheaper than the cost of directly owning the 100 shares of Apple in the example above.
When You Think an Asset Is Going Down in Value — Use a Put Option
Put options work the opposite way of call options. Say you think Tesla actually sucks. You think that its stock is going to fall from $300 per share by June 1. You buy a put option that states you have the right to sell 100 shares of Tesla at the $310 strike price by that date.
Your negative instincts were right, and Tesla’s stock plummets to $250 within the month. However, because of your put contract, you can now buy these $250 shares and sell them each for $310, a profit of $60 per share (minus the cost of the option and broker fees).
Popular Options Trading Strategies
As you already know, there's much more to options than just buying and selling calls and puts. There are options strategies for making bets (speculating), reducing risk and generating income. Some strategies make a profit when a stock goes up. Some do well when a stock goes down. And some are designed to do best when things stay calm. You can also apply these strategies to the overall stock market, using options on an index such as the S&P 500.
Many strategies have amusing names such as “spreads,” “straddles” and “strangles.” Keep reading and soon you'll be able to talk about them without snickering or wondering if you just said something inappropriate in mixed company.
#1 Covered Calls
Probably the best-known options strategy is writing (selling) “covered calls” (versus “naked calls” — really). With this strategy, you sell call options on a stock you own. You earn money for being willing to sell that stock at a given strike price. (The strike price, aka “exercise price,” is the price at which the option can be exercised.) When you sell a call option, you usually set the strike price a bit higher than the current price, so the call options you write are “out of the money.” Writing a call is a bet that the stock price won't go above the strike price before the options expire. In such a case, the money you received from selling the calls is pure profit. If your stock goes down, at least the money you received makes you a little less sad.
Worst-case scenario? The price of the stock does rise above the strike price and you do have to deliver your stock. You then receive a cash payment equal to the call's strike price times the number of shares. This could be a problem if you didn't already own the stock, since you would have to buy shares at the market price. This price will often be higher than what you received for the shares.
But in the “covered call” situation you're ok — you're “covered” (not naked). You already own the stock you have to deliver, and you keep the option premium.
If you decide you still want to own that stock, you'll have to buy it again in the open market. The cost will likely be higher than the strike price you received, but you have the strike price plus the money you were paid for selling the calls.
Example of Covered Call Outcomes
Here's an example. You own 100 shares of XYZ Corp., currently trading at $47. You sell a call option for those shares at a strike price of $50. These options are priced at $3.50 per share, so that's $350 in your pocket for options on your 100 shares. There are two possible outcomes for this strategy:
Outcome #1: The price of XYZ stays below $50, and the options you sold expire. You keep the $350 option premium and your 100 shares of stock that are worth something less than $5,000.
Outcome #2: The price of XYZ goes above $50, and the options are exercised. You deliver your 100 shares of stock for $5,000 ($50 strike price times 100 shares), and you keep the $350 option premium.
With Outcome #2, if you still want to own the stock you could use your $5,350 to buy another 100 shares. The price would have to go above $53.50 before you would have been better off not writing the covered call options.
A Higher Return Than the S&P 500
Writing covered calls on the S&P 500 index with a strike price roughly 8–10% above the current value of the index has, over a 30-year period, offered a higher return than just holding the S&P 500 itself. However, writing covered calls isn't a “win” all of the time. There's no such thing as a “sure thing” with investing. If your stock or the S&P 500 makes a strong move up in a short period of time, you'd be better off just holding the stock or the index.
#2 Bullish Spreads
Let's say you're thinking of buying a stock during the next few months. You want protection against the price going up too much before you jump in. You could just buy call options, but that requires more money up front than you want to spend.
What should you do in Bullish Spreads?
A bullish call spread could be the answer. You buy calls at a chosen strike price. At the same time, you sell the same number of calls at a higher strike price. Both options have the same expiration date. The calls you buy (with the lower strike) will cost more than the ones you sell (with the higher strike), but the money you receive from selling partially offsets the cost of buying.
This “vertical spread” strategy may be appealing if you expect a modest rise in the stock price. Worst-case outcome? The stock goes up by a lot — higher than the strike price of the calls you sold. But you're ok. You exercise your call options with the lower strike price. Now you own the stock, so you're in a covered call situation. And you made profit from the difference of the two strike prices. You bought at the lower price, let's say $45, and sold at the higher price, say $50. So, you made a $500 profit on 100 shares, less the amount you paid for the call spread.
If the stock price goes down, you've lost the money you paid for the calls you bought, but that's reduced by the income from the calls you sold.
#3 Bearish Spread
This is similar to the bull call spread. But in this strategy, you use puts instead of calls. You buy puts at a chosen strike price and sell the same number of puts at a lower strike price, on the same stock, with the same expiration date. As with the bull call spread, the money you receive from selling partly offsets the cost of buying. You might do this if you think a stock is going to decline but don't want to pay the full price of the puts.
If the stock declines below the first strike level, you deliver shares and receive the strike price, generating a profit. If the stock price goes below the lower strike on the puts you sold, you'll have to pay that strike price and will receive shares of stock that are now worth less than that. If the stock drops sharply, this can be risky.
Say you've owned a stock for a while and it has done well for you. You're not ready to sell, but you don't want to lose your gains if the stock takes a tumble. What can you do? Put on a collar. This consists of buying out-of-the-money puts (the strike price is below the current stock price) and selling out-of-the-money calls (the strike is above the current stock price). Buying the puts provides downside protection, while selling calls offsets the cost of buying the put. Note that you don't even have to own the underlying stock to “wear” this collar.
#5 Straddles and Strangles
Suppose you think a stock (or the overall market — remember those S&P 500 options) is going to be volatile over the next few months, but you're not sure which direction it will go. In this case, consider a straddle or a strangle. You buy puts and calls, either with the same strike price (a straddle) or different strikes (a strangle). With a strangle, the put's strike is typically lower than the call's, and the current stock price is in between those two amounts. It will cost you the price of both the puts and the calls, but if the stock does make a big move, either your calls or your puts will pay off.
Conversely, if you think a stock is likely to trade in a fairly tight range, you could use a short straddle or strangle. You sell (short) both call and put options and pocket the proceeds. With a short strangle, if the stock price stays between the call's strike and the put's strike, neither option is exercised, so you simply keep those proceeds.
With a short straddle, you have no “wiggle” room. One of the options you sold will be exercised, and you will incur a loss on that. But you earned money from selling the options in the straddle. Hopefully that amount is more than the loss from the option exercise. As long as the stock doesn't make a big, sudden move, it will be.
Hopefully you now have a good idea of how you can use options to make money whether a stock goes up or down.
There are strategies out there that are even more complex. These include some that “fly” (butterflies, condors, even an albatross) and some whose names could really make you blush. (How about a “strip straddle” — yup, that's a real thing.) Before you implement any of these strategies, you may want to practice with one or more option trading simulation platforms (such as TD Ameritrade). And if you come up with a strategy of your own, be sure to give it a name that makes people smile.
(Important note: Before you start trading options, make sure that your broker has cleared you for “take-off.” You'll need to fill out a special for to receive clearance. Here's more info about the process.)