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Options and Option Strategy

Options are a tricky subject.  During the Great Recession option trading came in for some somewhat deserved criticism.     There are some extremely significant risks to options trading when done wrong.  While this is definitely a more advanced investing option, there may still be some value in this asset class to you.  

So what are options?  At their most basic they are just agreements to purchase or sell stock in the future between two people.   There are actually two types of options:

Call Options

A call is when one person sells a right to purchase an asset, like a stock, for a specific price, or strike price.  This call option is sold for execution before a specific date, or expiration date.    The holder (or purchaser) of a call has the choice of whether to execute the option.    Holders of that right would then execute that call option if, and only if, the stock increased in value beyond that strike price.      The holder would then profit based on the difference between the current price of the stock and the call option amount after the call purchase price.

Call Profit (or loss) for Holder= Stock price- Call Option Strike Price – Cost of Call

The seller of the call option meanwhile receives a fixed amount for their call option in the form of the price for which they sell the call.    In general, the call option seller does not want the call to be executed so the can maximize their profit.  Any execution of the call reduces their profit by the amount of profit the holder receives.

Call Seller Profit= Call Sale Price – (Stock Price-Call Option Strike Price (If executed))

The important thing to realize is the buyer/holder of a call has risk equal to the price they paid to buy the call.  They have potential unbounded upside depending on how much the stock goes up.  The seller of a call meanwhile has fixed profit based on the Call Sale Price.   Sellers of a Call meanwhile have an unlimited potential downside as the price of the underlying asset increases.  You can limit these potential losses as a seller by holding the underlying asset.  Then in the worst case you can provide that asset as part of the call.

Put

A Put works the opposite way of a Call.  Essentially the holder of a put has the right to sell the underlying asset to the seller at a given price, or strike price.  Again they must execute the Put option before a specific date, or expiration date.  The holder of a put again has the choice on when to execute.  Put holders would execute that call option if, and only if, the stock decreased in value below the strike price.  The holder would then profit based on the difference between the current price of the stock and the call option amount.

Put Profit for Holder= Put Option Strike Price – Stock PricePrice of Put

The seller of a put option meanwhile receives a fixed amount for their put option in the form of the price for which they sell the put.  In general, the put option seller does not want the put to be executed so they can maximize their profit.  Any execution of the put reduces their profit by the amount of profit the holder receives.  

Put Seller Profit= Put Sale Price – (Put Option Strike Price (If executed)- Stock Price)

The important thing to realize is the buyer/holder of a put has risk equal to the price they paid to buy the put.  They have potential unbounded upside depending on how much the stock goes down.  The seller of a put meanwhile has fixed profit based on the Put Sale Price.   Sellers of a Put meanwhile have potential downside equal to the total cost of the asset – the sale price of the put as the price of the underlying asset decreases towards 0. 

In Summary, in a vacuum:


Stock Up Stock Down
Call Holder Unlimited Gain Fixed Loss
Call Seller Unlimited Loss Fixed Gain
Put Holder Fixed Loss Gain Up to Value of Asset
Put Seller Fixed Gain Loss of Total Value of Asset

Mitigating Option Risks

So obviously certain positions for options can be very costly to the average investor. There are, however, ways to mitigate some of these risks. In the case of the call seller, the unlimited loss can be limited by holding the underlying stock. Then if a call is issued the seller merely provides the underlying asset rather then having to buy it to provide it to the call holder. This is called a covered call.

There are also covered puts, usually involving some type of short position. However, it is important to note such positions potentially open up additional upside risks. I do not ever recommend shorting stocks, even with a goal of hedging.

2008 Options and the Market Crash

Obviously the problems back in 2008 related to institutions taking long uncovered calls and puts where they exposed themselves to uncovered unlimited loss, also known as naked calls and puts.  This is the advanced part of this process, the one you as a regular investor should avoid except in specific scenarios.

The Value of Options to the Retail Investor

But this doesn’t mean options are not potentially useful to you as an investor.   There a few options trading strategies that can be used under the right circumstances to juice your returns.    A note, these all involve a minor amount of market timing.  I tend to use some of these only in my play portfolio.  Still, their usage might come of value to you the reader.

Collar

The first option is what is called a Collar.  A collar is where you buy both a call and a put on the same asset.  The call and put are bought at different prices, the put being low and the call being high.  It’s essentially a bet that the stock will change in price, volatility, without regard for the direction.    If you are convinced the market will be volatile you can purchase these options to make money with a fixed potential loss only if the price falls between the collar.    A seller can do this collar in reverse to bet on a stock’s lack of volatility, but again the important thing to remember is most sellers of options have unbounded risk.  That is not something most investors should take.

Buying a Put as a Loss Limit

The second option is to buy a put.  Imagine you hold an underlying stock where you have made a considerable profit since purchase.  You want to lock in those gains.  Well by purchasing a put you lock in the future sale price of that stock for a minimum fee.  It’s insurance against losing your already achieved gains without actually selling the stock. A note, this strategy may not be cost-effective depending on put price.

Selling a Put as a Buy Limit Order

The third option is to sell a put.    Wait, didn’t I just stated that would cause downside risk up to the total value of the asset for fixed gain?    Well yes.  However,  Imagine you want to purchase an underlying stock once it drops below a given price.  You could place a limit order for that stock at that price and then wait for it to fall.    When you purchased you would then, as any stockholder, hold the risk of the total value of the asset if it fell to 0 just as you would by selling a put that was executed.  But by selling the put you also gain the price the buyer of the put paid.  So essentially selling a put can be used to replicate a limit order when used appropriately.

Selling a Call as a Sell Limit Order

The fourth option would be the covered call we mentioned earlier.  Say you want to sell a stock near your perceived top of its price range and you already hold the position.   You might set a limit order to sell the stock if it goes beyond a certain price.  Alternately you could sell a call of that stock at the price where you would sell the stock in terms of upside.    Then when the item is called you receive that sale price plus any price for the sale of the price.  If the stock doesn’t go up, meaning the call is not executed, then you receive the price but still hold the underlying stock.  

Buying Gives Control, How I Use Options

As you can see buying a put or call gives you the control on when to execute. In these cases, you control the situation and thus limit the potential losses or gains.  Selling puts you at some risk.   I tend to favor control of risk for most of my investments, so you would expect me to say I only favor buying calls or puts.  Well not in this case.  Personally, I only use option three.  I sell puts sparingly in my play account.  I do so in place of limit orders for purchase in our play money account.  Generally, I do not play volatility, hedge stock gains with a cover call or put, or engage in any other activity.    But I have been known to want to buy a stock when it dips below a given point.  In my case sometimes I will sell a put to make a higher profit off this action.

Do you use options?

I am not a financial advisor.  Any actions you take as a result of reading this site are your’s alone.  Full Time Finance is for entertainment purposes only.

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