Credit: Shutterstock photoWhile trading options can be a lucrative practice for "vanilla" bulls and bears, these investment vehicles can be traded fit to almost any outlook on a stock. Today, we will discuss the details of buying and selling options, and the underlying goal, maximum reward, and maximum risk of each trading strategy.
Buying Put Options
If you are bearish on a stock, you can profit off its decline by buying a put option . Purchasing to open a put is the closest thing to shorting 100 shares of an underlying security. In the simplest terms, a trader will buy a put option on a stock if they think its price will drop below the strike price within the option's lifetime. A "vanilla" trader's goal, then, is to profit off the stock's fall.
Another reason to buy puts is to protect the shares you own. While a shareholder may feel great about a stock's long-term future, concerns about a dip in the short-term -- possibly with earnings on the horizon -- could prompt that trader to buy protective puts . As with all insurance policies, the protective put buyer isn't hoping for the worst, but rather hedging just in case. His or her goal is still for the underlying stock to rally, but the purchased puts lock in an acceptable exit price, should the shares take a turn for the worse.
Selling Put Options
Typically, a short put is implemented when a trader thinks a stock is likely to hold above support, but a significant rally is not expected. A trader would simply sell a put at the strike price they believe will likely hold as a floor for the underlying stock through options expiration. The seller collects the premium up front, and hopes the option remains worthless through its lifetime. As such, put sellers
Buying Call Options
A "vanilla" trader will purchase a call option when they think the underlying equity will rise above the strike price within the options' lifetime. Just how buying a put option is the closest thing to shorting, buying a call option is the closest thing to purchasing outright stake in an equity, yet long calls often provide more leverage than buying the stock.
Meanwhile, short sellers often buy call options -- particularly at out-of-the-money strikes -- to hedge their bearish bets. The short seller is hoping the underlying shares move lower, but the protective call will limit risk in the event of a pop to the upside.
Selling Call Options
Conversely, selling to open a call option means the trader believes the equity will remain below the strike price through expiration. Therefore, speculators selling calls tend to focus on strikes that align with resistance on the charts. The seller will receive the premium upfront, with the goal that the sold option expire worthless.
However, the seller will also have to shell out a margin requirement to their broker to enter the position. Due to the high risk involved in a short call (described below), they'll be required to deposit a fixed amount into a margin account to cover potential losses. These requirements can vary from one firm to another, and they may also change with shifting market conditions -- so check with your broker to verify how much cash you'll need to secure your short call.
Risk vs. Reward
At first glance, buying a put option or selling a call option may seem virtually identical. The same can be said for selling a put option and buying a call option. It can get confusing! The difference between buying and selling lies in the difference between "right" and "obligation."
The reward for a put buyer will increase the lower the underlying stock goes south of breakeven (strike price minus initial premium paid) within the option's lifetime. The reward for a call buyer is theoretically unlimited, and will increase the higher the underlying stock moves north of breakeven (strike price minus initial premium paid) within the option's lifetime.
The maximum reward for both put and call buyers is limited to the initial premium paid for the options. That's why traders should pay close attention to implied and historical volatility figures, and note that option premiums tend to be more expensive ahead of potential volatility catalysts like earnings.
A put buyer has the right to sell the shares at the underlying strike price, should the option move into the money, while the call buyer has the right to buy the shares at the strike. However, if assigned, put sellers are obligated to buy the stock at the strike price, and call sellers are obligated to sell the stock at the strike price. As such, the options seller takes on more risk, which increases the further the underlying shares move against them. The maximum reward, meanwhile, is the initial premium received from the sale.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
