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Call options & put options

Buying and selling options can be very complex and very risky, so make sure you know what you're getting into before you start.

POINTS TO KNOW

  • There are 2 basic kinds of options: calls and puts.
  • When you buy either type, you have the ability to exercise the option if it benefits you—but you can also let it expire if it doesn't.
  • You can make money by selling your own options (known as "writing" options). Because the buyer is the one deciding whether or not to exercise the option, writing options can be much riskier.
  • Because of the additional risks and complexity, you need to be specifically approved to buy or write options.

What are options?

There are 2 major types of options: call options and put options.

Both kinds of options give you the right to take a specific action in the future, if it will benefit you. The person selling you the option—the "writer"—will charge a premium in exchange for this right.

When you buy an option, you're the one who will decide if you want to "exercise" the option sometime before the expiration date. If exercising it will cause you to lose money, you can simply let it expire. That way, the only money you'll lose is what you spent on the option itself.

Two types of options

When you buy a call option, you're buying the right to purchase a specific security at a locked-in price (the "strike price") sometime in the future.

If the price of that security rises, you can make a profit by buying it at the agreed price and reselling it on the open market at the higher market price.

When you buy a put option, you're buying the right to sell someone a specific security at a locked-in strike price sometime in the future.

If the price of that security falls, you can make a profit by buying it on the open market at the lower price and then exercising your put option at the higher strike price.

(Put options can also be used to hedge investments that you already own. You hope the investment will increase in value, but if it loses money instead, you can always sell it for the strike price specified in the option.)

Options contracts are typically for 100 shares of the underlying security.

Let's look at some examples.

What can happen when you buy options?


Scenario 1:
Share value rises.
Strike price for XYZ is $45. Stock price rises from $40 to $50.

IF YOU BOUGHT A CALL...

You execute the option and pay $4,500 for shares of XYZ worth $5,000, which you can keep or turn around and sell on the open market.

IF YOU BOUGHT A PUT...

You don't execute the option. Your loss is limited to the premium for the put.


Scenario 2:
Share value falls.
Strike price for XYZ is $35. Stock price falls from $40 to $30.

IF YOU BOUGHT A CALL...

You don't execute the option. Your loss is limited to the premium for the call.

IF YOU BOUGHT A PUT...

You execute the option. You sell your shares of XYZ to the option writer for $3,500, even though they're now worth only $3,000.

If you bought those shares of XYZ on the open market, you keep the $500 cash difference between the two amounts. If you already owned the shares of XYZ, you'll receive a higher price for them than you would have otherwise.


Writing options

When you write an option, you're the person on the other end of the transaction.

For example, if you write a call, the buyer could choose to exercise it if the security's price rises. You would then need to sell him or her this security at the strike price—no matter what the security currently sells for on the open market.

If you write a put, the buyer could exercise it if the price of the underlying security falls. You would then need to buy that security from him or her at the strike price.

Risks of writing options

Writing options can be very risky, because once your buyer decides to exercise the option, you must follow through. So your potential losses could be substantial, even unlimited.

Uncovered options

The riskiest options are uncovered ("naked") calls. That's when you don't already own the security (or enough of the security) to sell the buyer if he or she chooses to exercise the call.

Because there's no limit to how high a stock price can rise, there's no limit to the amount of money you could lose writing uncovered calls. For this reason, many brokerages, like Vanguard, don't allow you to write uncovered calls.

Puts can also be uncovered, if you don't have enough cash in your brokerage account to buy the security at the option's strike price, should the option buyer choose to exercise it.

In that case, the additional risk is that you'll have to sell something else—or borrow from your broker—in order to raise cash to buy the security and close out the option.

Covered options

Even puts that are covered can have a high level of risk, because the security's price could drop all the way to zero, leaving you stuck buying worthless investments.

For covered calls, you won't lose cash—but you could be forced to sell the buyer a very valuable security for much less than its current worth. So there's no limit to your opportunity loss.

Let's look at some more examples.

What could happen if you write a call?


Scenario 1:
Share price rises.
Strike price for XYZ is $45. Stock price rises from $40 to $50.

IF YOU WROTE A COVERED CALL...

The buyer executes the option. You sell your shares of XYZ for $4,500, even though they're now worth $5,000.

IF YOU WROTE AN UNCOVERED CALL...*

The buyer executes the option. You buy 100 shares of XYZ for $5,000 and then sell them for $4,500. You lose $500 cash.


Scenario 2:
Share price falls.
Strike price for XYZ is $35. Stock price falls from $40 to $30.

IF YOU WROTE A COVERED CALL...

The buyer lets the option expire. You keep the premium charged for the call, along with your shares of XYZ.

IF YOU WROTE AN UNCOVERED CALL...*

The buyer lets the option expire. You keep the premium charged for the call.


What's the worst that could happen?

IF YOU WROTE A COVERED CALL...

The value of your shares of XYZ rises exponentially high, but you can't profit from them, because you have to sell them at the strike price.

IF YOU WROTE AN UNCOVERED CALL...*

The value of XYZ rises exponentially high, and you have to buy 100 shares at this price and then sell them at the strike price. Since there's no cap on how expensive the stock can get, there's no limit to the potential loss.


What could happen if you write a put?


Scenario 1:
Share price rises.
Strike price for XYZ is $45. Stock price rises from $40 to $50.

IF YOU WROTE A COVERED PUT...

The buyer lets the option expire. You keep the premium charged for the put.

IF YOU WROTE AN UNCOVERED PUT...

The buyer lets the option expire. You keep the premium charged for the put.


Scenario 2:
Share price falls.
Strike price for XYZ is $35. Stock price falls from $40 to $30.

IF YOU WROTE A COVERED PUT...

The buyer executes the option. You buy the shares of XYZ for $3,500, even though they're only worth $3,000. On paper, you've lost $500.

IF YOU WROTE AN UNCOVERED PUT...

You sell other stocks to raise $3,500. You then use that money to buy the shares of XYZ, which are currently worth only $3,000. On paper, you've lost $500, plus whatever you lost in raising the cash.


What's the worst that could happen?

IF YOU WROTE A COVERED PUT...

XYZ becomes worthless, but you have to buy 100 shares at the strike price anyway. Therefore, the maximum loss is the value of the shares at the strike price.

IF YOU WROTE AN UNCOVERED PUT...

XYZ becomes worthless, but you have to buy 100 shares at the strike price anyway. Because you may have to borrow to raise the cash to buy the shares, your loss might be higher than the value of the shares at the strike price.


Find out more about trading options

Because of the additional risks and complexity associated with puts and calls, you have to be preapproved to trade them.


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