Calls & Puts

Long Call 

Long means we’re the buyer, and call gives us the right to buy a stock. So in this case we are spending money to buy the option (premium) which will give us the right to buy the stock at a set price in the future.

As the holder of the option, we’re going to hope the stock is higher than our strike price at expiry, and we can therefore make a profit. If we’re holding a $150 strike call option at expiry, and the stock is trading at $200, then we have a profit of $50 per share. If the stock is trading at $100, then our contract giving us the right to buy at $150 is worthless, and our option will expire worthless- we’re not going to exercise our right to buy at $150 if the stock is only trading at $100 in the market.

Short Call 

Here we are the opposite position of the above trade. We are the seller of a call option (writing a call option). So we’re giving someone else the right to buy stock from us at a future date. As we’re agreeing to sell a stock to someone in the future, then we either need to own that stock, or be prepared to buy it in order to deliver it to them.

Short calls can make a lot of sense if you own a big chunk of a stock, and you think perhaps it’s fully valued. You can create a nice additional income from the position by consistently selling calls 5,10 or 15% out of the money.

If the stock price doesn’t rise above your strike levels, you simply get to keep whatever premium you received from selling the calls. If the stock price does rise, then you get the benefit of the stock price upside up to the strike level, and then you’re selling some stock.

Selling calls on a stock you don’t own is known as selling naked calls. And while some things are great naked, selling calls isn’t one of them. The problem is, you’re agreeing to sell something you don’t own, for a fixed price in the future. Let’s say you sell $200 strike UPS calls naked. If UPS rallies to $300, you’re going to have to buy stock in the market for $300 to then deliver under the option contract and you’ll only get paid $200 for those same shares.

Now, while it doesn’t sound too bad in that your loss was only $100 per share, the problem is that your potential loss in this scenario is technically uncapped- because while stock prices can’t fall any lower than zero, stock prices don’t have an upper limit to them. Textbooks will tell you that this means your risk is unlimited. In reality, clearly stocks can’t just go up forever, and if UPS is $200 now it’s unlikely to be at $50,000 in a few months. But, the fact remains, you’re opening up an unknown level of risk by selling naked calls. To me, that’s an unnecessary risk you should simply avoid.

Long Put

Long puts allow you to profit from price declines. Here you’re buying the right to sell a stock at a set price. They are typically used either as ‘insurance’ to hedge an existing position, or as speculative trades to make money from share price falls.

Let’s say you buy Puts on UPS with a strike price of $150 and a 3 month expiry, while the stock is trading today at $180. If in 3 months’ time the price of UPS is $150 or higher, your puts will expire worthless, and you’ll lose whatever you paid for them in premium terms. However, if UPS has dropped to say $120, you’ll make $30 profit on your puts, as you’ve got the right to sell something for $150 that’s trading at $120.

If you own the underlying (in this case UPS), then your profit long put will offset the loss you experience in holding the stock while it falls. If you don’t own the stock in question, then your long put simply means you’ll make money if the price falls.

You can buy puts on most stocks, as well as most indices. Buying index puts allows you to profit from overall market declines and can be a useful tool to manage portfolio risk levels.

Short Put

Here you are giving someone else the right to sell you stock at a set price- so in other words you’re committing to buying stock at a set price on a future date. This is where things start to get really interesting, and this is likely where you’ll generate the majority of your income from options.

So let’s say UPS is trading at $200- you really like the company and you want to own it, but you think $200 is a little expensive, you only want to pay $180 for it. You can go ahead and sell put options with a strike price of $180 (and get paid $10 to do so)- which is you giving someone else the right to sell UPS stock to you at $180- so you’re committing in advance to buy the stock at that agreed price.

If on expiry UPS is trading above $180 then whoever bought your option won’t exercise it (there’s no point in selling to you at $180 if they can sell in the open market for more), and it will expire worthless. (You get to keep whatever premium they paid you at the beginning.)

If instead UPS is trading at $140, and you’ve sold a put with a strike of $180, then bad news- you’re buying UPS at $180. Immediately this doesn’t sound fantastic- buying something for $180 that you otherwise could’ve bought for $140 in the open market. But- there are a couple of other considerations- firstly, you got paid premium to write this option, and you get to keep that $10 whatever happens, so your real cost comes down to $170 per share.

Buy you’ve still paid $30 too much though? Well, on the date you sold your put option, your other choice if you liked UPS stock was to buy the stock itself at $200- if you’d have done so you’d now be sitting on a loss of $60 per share, double the size of your loss from the short put trade.  

Now, some people might argue that you’re better off just holding cash and hoping you have inhumanly impeccable timing to buy UPS stock when it hits a price you find attractive. In reality few humans have sufficient emotional resiliency, luck or discipline to buy with impeccable timing. Options enforce disciplined trading, and also allow you to be paid for it.