Review

How to Trade Options for Beginners w/Examples

Types of Stock Options

  • Equity Options. These types of options are available on most listed and NASDAQ securities.  Normally, stock options have a deliverable of 100 shares of the underlying security per contract.  This means if you buy one call on Apple (AAPL), you have the right to purchase 100 shares of AAPL at an agreed upon strike price and expiration date (or before if an American-style option).  Some higher dollar amount securities offer mini-options which make them sell in smaller denominations to yield a more liquid options market.
  • Index Options. This option type differs from an equity option by settling in cash and typically with a multiplier of $100 per contract as opposed to an equity contract settling in 100 shares of stock.

As a note, the deliverable for an equity or an index option may change as a result of a stock split, reverse stock split, stock dividend, merger, or other action.

Options Contracts Strategies

When people consider options, the two most common strategies consist of purchasing a long call or long put.  

The former allows the investor to buy a call and profit should the market price move north above the option’s strike price.  The latter produces a positive return when the market price heads south below the option strike price.

Long Call Options

For the long call option, depending on the price movement of the underlying stock, the gains can represent significant capital appreciation.  

This is because a 1% change in stock price does not necessarily represent a 1% gain in the option value.  

Rather, if the investor forecasts the future stock price appreciation accurately, the percentage gains can be substantial relative to the original options investment.  Specifically, the gains move in proportion to the option premium paid, not to the stock price itself.  

For call buyers looking to lock in profits, they can wait for higher volatility like a market-moving event, major announcement positively-affecting the stock, or some other exogenous event.  

During these moments, stock prices tend to fluctuate considerably as the markets attempt to find a new equilibrium price.  These events present an opportunity for call option owners to sell the call option prior to expiration and recognize a gain on sale.

Depending on the duration of holding the option, these gains can qualify for short-term (<1 year) or long-term capital gains (1 year or longer).

Long Put Options

Likewise, long put option owners can take advantage of this same volatility to capture gains on downward stock price movements.  Because exercising a put results in selling the underlying asset at a specific price (strike price), this presents a beneficial outcome when stock prices fall.

In effect, holding a long put yields a similar outcome as shorting a stock, though your losses are limited to the premium paid for the put option.  For investors looking to capitalize on market volatility, selling the put option prior to expiration can produce positive results.

The key point of focus revolves around another type of risk discussed for call buyers as well: market-timing risk.  Both financial instruments rely on timing your investment decisions and inherently expose the investor to added risk.

However, exercise good decision-making and you will find yourself rewarded.  Now, let’s take a look at some other common options strategies investors use either to (1) hedge risk in their portfolio or (2) leverage returns in anticipation of stock price movements.

1. Covered Equity Options

The buyer of long options must pay 100% of the purchase price for equity options.  The buyer will need cash or equity in the account at the time of placing the order and will be subject to 100% Regulation T and maintenance requirements.

  • Writing a covered call means selling the right to another party to buy a security from you at a specific price on or before the expiration date (American vs. European-style).  By establishing a short call position, the writer of the call option assumes an obligation to sell the underlying security if assigned on the options contract (counterparty forces the options contract).

If the call-option writer owns the underlying deliverable shares, then the options contract is “covered.”  If assigned, the writer can deliver the shares instead of purchasing them on the open market.

Therefore, the covered call writer does not need to find additional funds whereas an uncovered call writer would.  Stock serves as the backing for the call.

The underlying security for the covered call cannot have a higher value than the strike price of the short call for margin requirement purposes.

Motivation: Investor writing the call hopes the value of the stock deteriorates and can capitalize by collecting a premium from writing the call.

Maximum Gain: The premium collected from writing the call option.

Maximum Loss: Unlimited (stock could rise infinitely).

Breakeven: When the market price for the underlying stock is above the strike price in an amount equal to the premium received.  In other words, when the intrinsic value of the option equals the price at which it was sold.

  • Writing a cash-secured put means an investor creates an obligation to purchase the underlying security at the agreed-upon strike price on or before the expiration date.  The put option writer assumes the obligation to purchase the underlying security if the options contracts become assigned.

The investor would choose to write a cash-secured put when at-the-money or out-of-the-money and simultaneously setting aside enough funds to buy the underlying stock. 

If the put-options writer maintains a cash balance equal to the total exercise value of the contract, the put contracts become “cash-secured.”  If the option is assigned, the put-options writer purchases the security with the cash which had been held to cover the put.

Motivation: This strategy’s primary goal aims to acquire stock for a price-sensitive investor. A cash-secured put writer wants to acquire the underlying stock through assignment.  Specifically, the investor hopes to be assigned and acquire the stock below today’s market price. Regardless of assignment, all outcomes are acceptable and the investor will receive premium income to improve the net results.

Maximum Gain: Premium received.

Maximum Loss: Strike price – premium received (substantial).

Breakeven: Because the investor hopes to acquire stock in this options trading strategy, the break even would occur even if the investor could sell the stock at the same effective price paid.  (Breakeven = strike price – premium)

 

  • Writing a covered put involves creating an obligation to purchase the underlying security at the strike price on or before options expiration.  The put writer assumes the obligation to purchase the underlying security if the options become assigned.

If the put-options writer has sold short the underlying deliverable shares and simultaneously written a put option, the put option is “covered.”  If the option is assigned, the put-option writer purchases the security and delivers it to the lending brokerage firm to “cover” the short equity position.

The short stock can never be valued lower, for margin requirement purposes, than the strike price of the short put.

To illustrate this strategy, suppose an investor wishes to short Google stock at $1,200/share and sells 100 shares short.  At the same time, the investor sells $1,200 Google put options and collects $1,000 as a premium.

At expiration, Google stock remained at $1,200, leading to the maximum profit ($1,000).  The $1,200 Google puts expire worthless while the investor covers the short position.

Now, imagine if Google’s stock had fallen to $1,100 on expiration.  In this case, the short put expires in the money and is worth $10,000 (100 shares * $100/share decline) but the investor offsets this loss with the Google stock shorted (thus making this a covered put).

However, had Google’s stock rallied to $1,300, the investor experiences a significant loss.  

At this stock price, the short stock position taken when Google traded at $1,200 suffers a $10,000 loss (100 shares * $100 stock appreciation) offset only by $1,000 in premium credit.

The investor recognizes a net $9,000 loss.

Motivation: The investor aims for the stock price to fall and covers partially against a stock price increase with a premium collected on writing the put option. 

Maximum Gain:  The premium received.

Maximum Loss:  Unlimited.

Breakeven:  When the market price of the underlying security equals the premium received.

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