Call options and put options are the two primary type of option strategies. Below is a brief overview of how to profit from using these options in your portfolio.
Puts And Calls
A call option provides an investor with the right, but not the obligation to purchase a stock at a specific price. This price is known as the strike, or exercise price. A put option provides an investor with the right, but not the obligation to sell a stock at a specific price. This price is also known as the strike, or exercise price. Other important contract terms include the contract size, which for stocks is usually in denominations of 100 shares per contract. The expiration date specifies when the option expires, or matures. The contract style is also important and can be in two forms. American options let an investor exercise an option any time before the maturity date. European options can only be exercised on the expiration date. [See American vs. European Options]
Writing Call Options for Income
Buying a call option is the same as going long or profiting from a rise in the stock price. As with stocks, an investor can also short or write a call option, receiving the premium. The call writer has the obligation to sell the stock to the call option holder if the stock price rises above the exercise price.
In writing call options, the investor who is short is betting that the stock price will remain below the exercise price during the term of the option. As long as this happens, the investor earns income from the strategy along with the premium.
Three Ways to Profit Using Call Options
Combining One Call with Another Option
To create a more advanced strategy and demonstrate the use of call options in practice, consider combining a call option with writing an option for income. This strategy is known as a bull call spread and consists of buying, or going long a call option and combining it with a short strategy of writing the same number of calls with a higher strike price. In this case, the intention is to profit from a narrow trading range.
For example, assume a stock trades at $10, a call is purchased at a strike price of $15 and a call is written at $20 for a premium of $0.04 per contract. This assumes a single contract for premium income of $4, or $0.04 x 100 shares. The investor will keep the premium income regardless of the situation. If the stock remains between $15 and $20, the investor retains the premium income and also profits from the long call position. Below $15, the long call option is worthless. Above $20, the investor keeps the premium income of $4 as well as a $5 profit from the long call option, but loses out on any upside above $20 as the short position means the stock will be called away.
Writing Put Options for Income
Buying a put option is similar to going short on a stock, or profiting from a fall in the stock price. However, an investor can also short, or write a put option. This lets him or her receive the premium and hope the stock remains above the strike price. If the stock falls below the strike price, the put writer has the obligation to buy the stock (because it is effectively “put” to him or her) from the put option holder. Again, this occurs if the stock price falls below the exercise price.
When writing put options, the investor who is short is betting that the stock price will remain above the exercise price during the term of the option. As long as this happens, the investor earns income from the strategy along with the premium.
Combining One Put with Another Option
To create a more advanced strategy and demonstrate the use of put options in practice, consider combining a put option with a call option. This strategy is known as a straddle and consists of buying a put option as well as going long a call option. In this case, the investor is speculating that the stock is going to have a relatively significant move either up or down.
For example, assume a stock trades at $11. The straddle strategy can be relatively straightforward and consist of purchasing both the put and call at a strike price of $11. Two long options are purchased with the same expiration date and a profit is reached if either the stock moves up or down by more than the cost to purchase both options.
Assume shares of XYZ recently traded at $11 per share. A call option costs $0.20 and a put option costs $0.15 for a total cost of $0.35. In this case, the stock has to rally above $11.35 for the call option to pay off and below $10.65 for the put option to pay off.
The Bottom Line
These simple call and put option strategies can be combined with a vast array of more exotic positions to generate profits and control risk.