While there are many exotic-sounding variations, there are ultimately only four basic positions to trade in the options market: You can either buy or sell call options, or buy or sell put options. In establishing a new position, options traders can either buy or sell to open. Existing positions are canceled by either selling or buying to close.
Regardless of which side of the trade you take, you're making a bet on the price direction of the underlying asset. But the buyer and seller of options stand to profit in very different ways.
- There are four basic options positions: buying a call option, selling a call option, buying a put option, and selling a put option.
- With call options, the buyer is betting that the market price of an underlying asset will exceed a predetermined price, called the strike price, while the seller is betting it won't.
- With put options, the option buyer is betting the market price of an underlying asset will fall below the strike price, while the seller is betting it won't.
- Buyers of call or put options are limited in their losses to the cost of the option (it's premium). Unhedged sellers of options face theoretically unlimited losses.
- Spreads with options involve simultaneously buying and selling different options contracts on the same underlying.
What Do The Phrases “Sell To Open,” “Buy To Close,” “Buy To Open,” And “Sell To Close” Mean?
Trading Call Options
A call option gives the buyer, or holder, the right to buy the underlying asset—such as a stock, currency, or commodity futures contract—at a predetermined price before the option expires. As the name "option" implies, the holder has the right to buy the asset at the agreed price—called the strike price—but not the obligation.
Every option is essentially a contract, or bet, between two parties. In the case of call options, the buyer is betting that the price of the underlying asset will be higher on the open market than the strike price—and that it will exceed the strike price before the option expires. If so, the option buyer can buy that asset from the option seller at the strike price and then resell it for a profit.
The buyer of a call option must pay an upfront fee for the right to make that deal. The fee, called a premium, is paid at the outset to the seller, who is betting the asset's market price won't be higher than the price specified in the option. In most basic options, that premium is the profit the seller seeks. It is also the risk exposure, or maximum loss, of the option buyer. The premium is based on a percentage of the size of the possible trade.
Trading Put Options
A put option, on the other hand, gives the buyer the right to sell an underlying asset at a specified price on or before a certain date. In this case, the buyer of the put option is essentially shorting the underlying asset, betting that its market price will fall below the strike price in the option. If so, they can buy the asset at the lower market price and then sell it to the option seller, who is obligated to buy it at the higher, agreed strike price.
Again, the put seller, or writer, is taking the other side of the trade, betting the market price won't fall below the price specified in the option. For making this bet, the put seller receives a premium from the option buyer.
Call and put options have a risk metric known as the delta. The delta tells you how much the option's price will tend to change given a $1 move in the underlying security.
To Open vs. to Close
There are additional terms to know when executing these four basic trades. The phrase "buy to open" refers to a trader buying either a put or call option that establishes a new position. Buying to open increases the open interest in a particular option, and increasing open interest can signal greater liquidity and point to market expectations. "Sell to close" is when the holder of the options (i.e., the original buyer of the option) closes out their call or put position by selling it for either a net profit or loss. Note that options positions will always expire on the expiration date for a particular contract. At that point, in-the-money options will be exercised and out-of-the-money options will expire worthless. There is no need to sell to close if an options position is held to expiration.
A trader may also "sell to open," establishing a new position that is short either a call or a put. A short put is actually taking a long position in the underlying market because put options rise in value as the underlying price declines. When you sell an option "naked" (i.e., unhedged), the option seller (known sometimes as the writer) is exposed, in theory, to unlimited risk. This is because the seller of an option receives the premium at the time of the trade, but if a short call position sees a rapidly rising underlying market, they can quickly see losses mount. "Buy to close" means the option writer is closing out the put or call option they sold.
Other Options Terminology
In addition to these four basic options positions, traders can also use options to build spreads or combinations. A spread involves buying and selling options together on the same underlying, while a combination is buying (selling) two or more options. Here are a few basics:
- Vertical call/put spread: Buy (sell) one call (put) and sell (buy) and more out-of-the-money call (put). Vertical spreads that profit in up markets are bull spreads; in down markets bear spreads.
- Calendar Spread: Buy (sell) an option with one maturity to sell (buy) an option with a different maturity.
- Straddle: buying both a call and a put of the same strike and expiration
- Strangle: buying both a call and a put at the same expiration but different (out-of-the-money) strikes.
- Butterfly: a market-neutral strategy involving buying (selling) a straddle and selling (buying) a strangle
- Covered Call: sell shares against an existing stock position.
- Protective Put: buy shares against an existing stock position.
Is Trading Options Good for Beginners?
Options are more complex than basic stocks trading and require margin accounts. Therefore, basic options strategies may be appropriate for certain beginners but only after all risks are understood as well as how options work. In general, options used to hedge existing positions or for taking long positions in puts or calls are the most appropriate for less-experienced traders.
What Is the Difference Between a Call Option and a Put Option?
A call option gives the holder the right (but not the obligation) to buy the underlying asset at a specified price at or before its expiration. A put contract instead grants the right to sell it.
Can I Lose Money Buying a Call?
If you buy a call, the breakeven price will be the strike price of the call plus the premium (i.e., the price) paid for it. So, if a $25-strike call is trading at $2.00 when the share price is at $20, the stock would have to rise above $27.00 before it expires to break even. If not, the trader will lose up to a maximum of the $2.00 paid for the contract.