On this page, we’ll dig into the basic building blocks of option trades. We’ll look at what it means to both buy and sell puts or calls. We’ll talk about naked trades compared to various ways of securing or hedging trades. As we go through the various scenarios, we’ll walk through the potential risk and reward, both in theory and in practice.
Let’s start with a reminder of the difference between a call and a put.
A call contract gives the buyer the option to buy 100 shares of the underlying security from the option seller at the strike price any time until the expiration of the contract. The call seller is obligated to sell 100 shares at the strike price if and whenever the buyer chooses to exercise the option. The option has intrinsic value if the price of the underlying security is greater than the strike price. The intrinsic value is the difference between the underlying and strike prices. The call will also have time value, or extrinsic value, based on the amount of time left until expiration and how far apart the underlying and strike price are from each other.
A put contract gives the buyer the option to sell 100 shares of the underlying security from the option seller at the strike price any time until the expiration of the contract. The call seller is obligated to buy 100 shares at the strike price if and whenever the buyer chooses to exercise the option. The option has intrinsic value if the price of the underlying security is less than the strike price. The intrinsic value is the difference between the underlying and strike prices. The put will also have time value, or extrinsic value, based on the amount of time left until expiration and how far apart the underlying and strike price are from each other. Puts are a bit confusing to new traders because the buyer is buying one thing to be able to sell another. In time it becomes natural.
In both types of options, before expiration the buyer has three possible choices at any time. The buyer can do nothing and wait for expiration. The buyer can sell the option to close the position to any willing buyer at the current market price of the option. The buyer can exercise the option, triggering a transaction of the underlying at the strike price.
Before expiration the seller has two possible choices at any time and one potential obligation. The seller can do nothing and wait for expiration. The seller can buy back the option to close the position from any willing seller at the current market price of the option. But the seller may be assigned to fulfill the option, and be forced to carry out a transaction of the underlying at the strike price.
At expiration, if the option is out of the money, it expires worthless. If the option has value, most brokerages will automatically assign shares to be bought or sold on behalf of the option buyers from the option sellers.
When we talk about buyers and sellers, each transaction- opening, closing, exercising, or being assigned do not usually involve the same two traders. When options are bought or sold, the transaction may be an opening or closing trade for either or both. When the first contract is sold, both the buyer and the seller will be opening a trade. After that, contracts are bought and sold, closing one person’s position and opening another person. The options clearing house keeps track of all the open contracts, which can be seen in the open interest column of any online options price table.
For example, Bob sells an opening one contract option position to Mary, who doesn’t have a position. Mary turns around and closes her position she just bought by selling to Jim. There is still just one contract- Jim is the buyer and Bob is the seller. Later, Sally buys a contract for the same option from Ted, opening a position for both of them. Now there are two contracts open. Then, Bob decides to buy back his option and Sally sells hers, closing both their positions. Now there is only one position. Jim informs his broker that he wants to exercise the option. The options clearinghouse notifies Ted’s broker, and overnight 100 shares are traded between Jim and Ted at the strike price. Five transactions, five different people, and each trade between a different pair. In real life, it is thousands of trades between thousands of people, but the idea is the same.
Let’s move to the mechanics and implication of each type of trade.
BUYING A CALL
For most people, buying a call is the simplest option transaction to understand. A buyer buys a call option hoping the price of the underlying security will go up, making the call more valuable. The buyer can buy a call with a strike price below the current price of the underlying making it in the money, or a strike price the above the current price which would be out of the money.
The Reward
The buyer of a call has potentially unlimited profit, as the underlying can go way higher than the strike price. This is the appeal of buying calls for many- a small purchase can lead to a big payoff.
For example, a buyer buys a 105 call for a stock that is currently trading for $100. The cost of the call is $1. The next day the stock jumps to $155 due to an announcement of an upcoming merger. The option jumps to $50 (155-105) and the buyer sells the option for 50x what the purchase price was. This is the situation every call buyer dreams of. It almost never happens. I’ve had it happen once. I bought calls on LinkedIn for $3, and a few days later Microsoft agreed to buy LinkedIn for $70 over the current share price. I made nearly $7000 on a $300 buy.
The Risk
The risk is simple- you can lose all of the premium you paid and nothing more. Because of this, most people think of buying options as a limited risk, unlimited reward trade.
Probabilities
Here’s the problem with buying calls. In many cases, this is a low probability trade. The issue is that you must overcome the time value of the premium paid for the option and have the underlying move up before the option expires. The odds aren’t favorable.
One positive is that stocks tend to go up in value more often than down. Because option price skew favors out of the money calls with lower implied volatility, buying calls in many situations can be easier to overcome the premium for a profit.
The flip side of the historic trends are that although prices tend to drift up, they don’t often move up a lot in a short period of time. This makes calls that are well out of the money very low probability. This is reflected in the quick drop off in prices out of the money.
Looking at the delta value of the option at purchase will give the buyer a good idea of the odds of breaking even or better. A 40 delta call has a 40% chance of breaking even or being profitable.
Typical strategies
A buyer of out of the money calls can pay a fairly small amount to own a call, knowing that it could be a total loss.
Buyers of in the money options pay more for the option, but have a higher probability of profit. Many traders use deep in the money calls as a cheap substitute for buying shares of stock. A buyer can buy a 90 delta at a strike price around 5% below the current share price for possibly 10% of the price of the stock. CHECK THESE NUMBERS. If the stock goes up 5%, the buyer makes a 50% return on the trade. Example table. This is a classic way for a trader to use options to gain leverage. Of course leverage works both ways. If the stock goes down, the call buyer will lose a large portion of the premium paid if not all.
Because time works against a call buyer and time decays more rapidly near expiration, it is often beneficial to buy calls that have a long time until expiration. The buyer can then sell the option with time remaining without losing a lot of time value.
Time value also is higher when implied volatility is high. Buying calls when implied volatility is high makes generating profits doubly hard. If the price of the underlying goes up as hoped, volatility will go down, dragging down the price of the call option with it. This can be very frustrating for call buyers- when they are right on the direction of the move and the timing of the move, but still don’t make money.
Hedging a call
When purchasing a call, the biggest negative is time decay. This can be reduced or eliminated by selling a higher priced call, or a call expiring earlier that has a higher Theta, or similar time value. Hedging in this way limits the upside potential, but improves the odds of profitability. We’ll explore this more in later strategies.
Using a call as a hedge
Another reason to buy a call is to hedge a short stock position or a short call. If a person has sold shares short, they take on unlimited upside risk. Or as we will discuss shortly, selling naked calls also has virtually unlimited risk. However, buying a call at a higher strike price limits risk, often for a low price. My main use for buying calls is hedging risk of short calls. We’ll cover this much more as part of other strategies.
SELLING A CALL
Selling a call by itself is considered called selling a naked call. Most people think of this as a very risky transaction. A seller sells a call option hoping the price of the underlying security will go down, or at least stay below the strike price, making the call worthless at expiration. Typically, a seller chooses a strike price above the current price which would be out of the money with the expectation that the underlying price will not get to the strike price.
In regular margin accounts, traders can secure a naked call sale with margin and have to reserve a fraction of the underlying cost, usually around 18-20% of the strike price of the call. So, a margin secured call seller of a $100 strike price would have to keep an additional $2,000 cash in the account as sort of an insurance policy for the broker. However, the cash won’t be enough if the underlying jumps up by more than 20% before expiration. As the security increases in value, the broker will require the seller to hold more cash to protect the broker from the account going negative. This required cash increase is called a margin call. If the seller can’t come up with the additional cash, the broker will liquidate as many positions as necessary to prevent the seller’s account from costing the brokerage to take a loss. Because of all this complication, brokers generally save selling naked options on margin for the highest level of approval.
The Reward
The seller of a call has a maximum profit of the premium collected. The seller must have a very high win percentage to be profitable over the long haul.
For example, a seller sells a 105 call for a stock that is currently trading for $100. The premium collected for the call is $1. The stock goes up to $103 at expiration. Even though the stock went up, the option expires worthless and the seller keeps the $1 premium.
The Risk
The risk of selling a naked call is technically unlimited- the seller is liable for whatever gain the underlying goes up, theoretically to infinity. Brokers are very aware of this risk and require the highest level of approval to sell naked calls, and generally won’t approve naked call sales in any IRA accounts. Selling call options is a unlimited risk, limited reward trade.
However, from a practical standpoint, equities generally don’t go up quickly, so the real risk isn’t as bad as it seems. Recall that big stock movement, particularly during a month or two are skewed to the downside. ETFs in particular don’t generally have up moves that are well beyond expected moves. The bigger risk for large up moves come from individual stocks.
For example, a seller sells a 105 call for a stock that is currently trading for $100. The premium collected for the call is $1. The next day the stock jumps to $155 due to an announcement of an upcoming merger. The option jumps to $50 (155-105) and the seller now owes 50x what the sales price was. This is the situation every call seller should be aware of. Fortunately, it almost never happens.
One unique risk to selling calls is dividend risk. If a underlying pays a dividend, it can make a call more valuable as it approaches ex-dividend status. The buyer may exercise the call, forcing the seller to deliver shares to the buyer. But naked sellers don’t have shares, so the seller will have to sell the shares short and then also pay the dividend to the broker as short shares are borrowed.
Probabilities
Here’s the advantage of selling calls. In most cases, this is a high probability trade. Even with equities typically trending upward, the seller has both the difference of the strike price from the underlying, plus the amount of the premium to overcome.
Because option prices are skewed to lower implied volatility, the delta value tends to accurately predict success rates. Looking at the delta value of the option at purchase will give the seller a good idea of the odds of breaking even or better. A 40 delta call has a 40% chance of breaking even or being profitable. Buying back early when prices are in the seller’s favor can move the odds to the favor of the seller.
Typical strategies
A naked seller of out of the money calls strives to choose strike prices that collect meaningful premium at probabilities that are high. Many times a naked call is sold along with a put to take both sides of a move for more premium.
Naked sellers will typically not sell a call in the money or deep in the money, unless they for some reason want to end up having a short position at assignment.
Because time decays more rapidly near expiration, it is often beneficial to sell calls that are within a few months of expiration. Calls further out from expiration don’t decay enough to make sense to sell in most situations.
Time value also is higher when implied volatility is high. Selling calls when implied volatility is high can work well if volatility collapses. But, often volatility is high when prices have dropped suddenly, which is the only time when indexes have a history of making large up moves. So, sellers must proceed with care not to be whipsawed by moves when an equity is oversold.
One big strategic advantage of naked calls is the ability to roll out for additional premium. A seller can always buy the existing call option back and sell the same strike price at a later date for a credit. For example, a seller sold a $100 strike price call. As expiration nears, the underlying is trading at $102 and the option is trading for $2.10. The seller buys back the option for $2.10 and sells an option with a month later expiration for $2.50, a credit of $0.40 per share. The seller is paid to wait another month for trade to become profitable.
Hedging a naked short call
When selling a naked call, the biggest negative is unlimited risk. This can be reduced or eliminated by buying a higher priced call. Hedging in this way limits the upside risk, but reduces total premium. Instead of a naked call, the seller would have a call spread. We’ll explore this extensively in later strategies.
Using a call as a hedge
A very popular way to use the sale of a call is to sell a call on a security that the seller owns. This is a covered call. The call is covered by the underlying shares in the account. If the shares go up and the option is exercised, the shares in the sellers account are transferred out of the account. Since the call was sold for a premium, the seller will make money even if the shares are called away. While selling naked calls requires the top level of broker approval, selling covered calls is the easiest option strategy to be approved for. Many investors sell covered calls as their only option strategy in order to collect additional income. We’ll discuss this strategy extensively in the next chapter.
SELL A CALL 2
By selling calls, you are giving the buyer the right to buy your stock at the strike price of the call option at any time up until the option expires. Sellers make this trade in order to collect the premium from the option sale. The seller then hopes and expects the price of the underlying asset to stay below the strike price of the option. If the underlying price stays below the strike price at option expiration, the option will expire worthless. On the other hand, if the price of the underlying goes above the strike price, the seller will have to either buy back the option at a loss or sell shares of the underlying asset at the strike price, which will be a loss. Depending on the situation, this can be one of the safest trades you can make or the riskiest.
If you are selling the call and you don’t own the underlying stock or another call, you are selling a naked call. This is considered very risky, because there is theoretically unlimited risk.
For example, you sell 10 contracts on a 100 call in ABC stock, a small tech startup, for $1 per share and you collect $1000 into your account. The next day, Apple announces that they are buying ABC for $200 per share. Then, a hedge fund offers to buy the firm for $250. Finally, Apple ups their offer to $300. The stock jumps to $300. Your option is now worth $200 per share. To buy back your option, you’ll need $200,000, or you may be assigned to sell 1000 shares that you don’t have.
This is an extreme example. Although your risk with a naked short call is infinite in theory, from a practical standpoint big jumps in stocks are rarely double-digit percentages. Still, there are situations where this happens, especially in individual stocks after very good earnings or some type of other positive announcement. As a result, these types of trades require the highest level of option permission at most brokers, as well as substantial margin requirements.
Most people who sell calls already own shares in the underlying. This is what is termed a covered call. This is considered the most safe option transaction there is, because the shares that could potentially be called away are already owned by you. No matter how high the price may go, the only thing that can happen is that you have to sell the shares for the strike price of the option, and you still keep the premium from selling the option.
For example, if you own 200 shares of QQQ, you could sell 2 call contracts on QQQ. If you sell a 190 call and the stock is later trading for $200 per share, you may have the option exercised and you will be forced to sell your stock for $190. On the other hand, if you sold a 210 call and the stock is trading at $200 per share, no one will exercise the option because it would be cheaper to buy the stock on the market for $200 than to exercise an option to buy it for $210.
If we go back to our ABC stock example, and you owned 1000 shares of ABC stock and sold 10 calls with a 100 strike price, the situation would be very different. If the stock jumped up to $300, you would likely be forced to sell your shares for $100 each. Assuming you paid less than $100 per share each, you would have a profit on the overall position. You would miss out on your shares going from $100,000 to $300,000, but you wouldn’t have to come up with $200,000.
A third way to sell calls would be to buy an equal number of calls at a different strike price to protect from a large outsized move. This type of transaction is considered a spread which we’ll talk more about shortly.
If we go back yet again to our ABC stock example and we sell 10 contracts with a 100 strike price for $1, but we also buy 10 contracts with a 105 strike price for 20 cents a share, our total transaction will be a credit of $800 into our account (sale of $1000 minus a buy of $200). Now, if the stock jumps to $300, our options will be worth $200 and $195 per share respectively. We can close out the position for $5000 (buy back short calls for $200,000 and sell the long calls for $195,000). So, while the trade went badly against us, we lost $4200 ($5000-$800) instead of $199,000 in the naked call.
This is an extreme example to show why brokers consider this risky. In reality, most calls that are sold out of the money will expire worthless if held to expiration, and the seller can keep all the premium from the sale.
BUY A PUT
For most people, buying a put is a simple way to profit when the market goes down.. A buyer buys a put option expectinging the price of the underlying security will go down, making the call more valuable. The buyer can buy a put with a strike price above the current price of the underlying making it in the money, or a strike price below the current price which would be out of the money.
The Reward
The buyer of a call has potentially unlimited profit, up to the price of the underlying, as the underlying could go down to a price of zero. This is the appeal of buying puts for many- a small purchase can lead to a big payoff.
For example, a buyer buys a 95 call for a stock that is currently trading for $100. The cost of the call is $2. The next day the stock drops to $45 due to an announcement of an accounting change that re-states earnings. The option jumps to $50 (95-45) and the buyer sells the option for 25x what the purchase price was. This is the situation every put buyer hopes for. It almost never happens.
The Risk
The risk is simple- you can lose all of the premium you paid and nothing more. Because of this, buying puts are a limited risk, unlimited reward trade.
Probabilities
Here’s the problem with buying calls. In most cases, this is a low probability trade. The issue is that you must overcome the time value of the premium paid for the option and have the underlying move down before the option expires. The odds aren’t favorable at all.
While stocks can drop significantly at times, it doesn’t happen often enough to make put selling profitable. Because option price skew make puts more expensive than calls, buying puts are very expensive compared to the opportunity. The only time when odds are even close to positive is when volatility is low and the underlying is extremely overbought.
Looking at the delta value of the put option at purchase tends to overstate the probability of breaking even or better. A 40 delta call should have a 40% chance of breaking even or being profitable, but put implied volatility is usually overstated compared to actual performance.
Of the four basic trades, buying puts is the lowest probability trade. I never buy puts alone for this reason.
Typical strategies
A buyer of out of the money puts can pay a small amount to own a put, knowing that it could be a total loss. Often this is done when the buyer is concerned that the market is headed for a big drop.
Buyers of in the money puts pay more for the option, but have a higher probability of profit. Many traders use deep in the money puts as a cheap substitute for shorting shares of stock. Because time works against a put buyer and time decays more rapidly near expiration, it is often beneficial to buy puts that have a long time until expiration. The buyer can then sell the option with time remaining without losing a lot of time value.
Time value also is higher for puts when implied volatility is high. Buying puts when implied volatility is high makes generating profits extremely hard. Underlying prices are more likely to rise when volatility is high, and put premiums are very high when volatility is high.
Hedging a put
When purchasing a put, the biggest negative is time decay. This can be reduced or by selling a lower strike price put, or a put expiring earlier that has a higher theta, or similar time value. Hedging in this way limits the upside potential, but improves the odds of profitability. We’ll explore this more in later strategies.
Using a put as a hedge
Another reason to buy a call is to hedge a stock position or a short put position.
Many shareholders have positions they don’t want to sell, but they are concerned that the security price will drop. Buying a put provides insurance. However, that insurance is expensive.
As we will discuss shortly, selling naked puts has virtually unlimited risk. However, buying a put at a lower strike price limits risk, often for a low price. This is my main use for buying puts- hedging risk of short puts. We’ll cover this much more as part of other strategies.
SELL A PUT
Selling a put by itself is considered called selling a naked put. Most people think of this as a very risky transaction. I know I used to think this was the most risky trade you can make. A seller sells a put option hoping the price of the underlying security will go up, or at least stay above the strike price, making the call worthless at expiration. Typically, a seller chooses a strike price below the current price which would be out of the money with the expectation that the underlying price will not get down to the strike price.
There are actually two types of ways to sell naked puts, cash secured and margin secured.
A cash secured naked put means that the seller has to keep enough cash to buy the underlying security at the strike price. So, a cash secured seller that sells a $100 strike price put would have to have $10,000 cash on hand for one contract. If the seller collects a $2.00 premium, the account would collect $200 for the contract, but tie up $10,000 to cover the risk. Most IRAs that allow naked put sales will only allow cash secured put sales. Because the sale is secured with cash, there is no risk to the broker, so these trades are generally a fairly low level of approval at most brokers.
In regular margin accounts, traders can secure a put sale with margin and only have to reserve a fraction of the put cost, usually around 18-20% of the strike price of the put. So, a margin secured put seller of a $100 strike price would have to keep $2,000 cash in the account. However, the cash won’t be enough if the underlying drops by more than 20% before expiration. As the security drops in value, the broker will require the seller to hold more cash to protect the broker from the account going negative. This required cash increase is called a margin call. If the seller can’t come up with the additional cash, the broker will liquidate as many positions as necessary to prevent the seller’s account from costing the brokerage to take a loss. Because of all this complication, brokers generally save selling naked options on margin for the highest level of approval.
The Reward
The seller of a put has a maximum profit of the premium collected. The seller must have a high win percentage to be profitable over the long haul.
For example, a seller sells a 95 call for a stock that is currently trading for $100. The premium collected for the call is $2. The stock goes down to $96 at expiration. Even though the stock went down, the option expires worthless and the seller keeps the $2 premium.
The Risk
The risk of selling a naked put is virtually unlimited- the seller is liable for whatever loss the underlying gives up, theoretically to zero. Brokers are very aware of this risk and require the put to be secured either 100% with cash or with margin. Selling call options is an unlimited risk, limited reward trade.
Let’s look at an example, a seller sells a $100 strike price naked put for $2. The seller collects a total of $200 for the sale (100 x $2). But what happens when the underlying then drops 40% to $60 a share? The buyer would likely exercise the option, putting the shares to the seller at a cost of $10,000 (100 x $100). But the shares are only really worth $6,000, so the seller will be down $3800- the seller collected $200, but had to pay $10,000 for a security that is worth $6,000. The cash secured put seller loses a lot of cash, but the margin secured seller owes $1,800 more than the $2,000 cash that was in the account.
Big drops like this really do occur, particularly for individual stocks, so this isn’t a theoretical discussion. A naked put seller needs to have a risk management strategy to avoid being wiped out by a big drop. We’ll discuss some approaches for this later in the book.
However, most of the time, equities generally don’t often drop below the margin requirement, so the real risk doesn’t occur very often. Recall that big stock movement, particularly during a month or two are skewed to the downside. It is easy to get complacent when this doesn’t happen for a long time.
Probabilities
Here’s the big advantage of selling puts. In most cases, this is a very high probability trade. With equities typically trending upward, the seller has both the difference of the strike price from the underlying, plus the amount of the premium to overcome, and the equity usually moving in their favor.
Because put option prices are skewed to higher implied volatility, the delta usually overstates the risk. Looking at the delta value of the option at purchase will give the seller a good idea of the odds of breaking even or better. A 40 delta put generally has a better than 40% chance of breaking even or being profitable. Buying back early when prices are in the seller’s favor can move the odds even more to the favor of the seller.
Typical strategies
A naked seller of out of the money puts strives to choose strike prices that collect meaningful premium at probabilities that are high. Over enough different put sales, a seller can generally make a very good profit.
Interestingly, when volatility is high and puts are the most expensive, they tend to be the most profitable as well. Remember that when volatility is highest, the average future underlying price increases the most. Time value also is higher when implied volatility is high. Selling puts when implied volatility is high can work well if volatility collapses. Volatility is high when prices have dropped suddenly, which is the only time when indexes have a history of making large up moves. So, put sellers benefit from underlying prices that whipsaw with up moves when an equity is oversold. The benefit is both a price change to their benefit and volatility collapse.
When volatility is low, it can help to pair a naked put sale with a naked call sale. We’ll talk later about the advantages of these types of combinations.
Naked sellers will typically not sell a put in the money or deep in the money, unless they for some reason want to end up having an equity position at assignment. With a cash secured account, a seller can sell a put at the money or even in the money and wait to be assigned the underlying equity. The seller essentially gets paid to buy the equity. I’ve done this a few times- it is actually a fairly conservative strategy, but not usually a high return on capital. We’ll talk about this strategy later.
Because time decays more rapidly near expiration, it is often beneficial to sell puts that are within a few months of expiration. Puts further out from expiration don’t decay enough to make sense to sell in most situations.
One big strategic advantage of naked putss is the ability to roll out for additional premium. A seller can always buy the existing put option back and sell the same strike price at a later date for a credit. For example, a seller sold a $100 strike price put. As expiration nears, the underlying is trading at $98 and the option is trading for $2.20. The seller buys back the option for $2.20 and sells an option with a month later expiration for $4.20, a credit of $2.00 per share. The seller is paid to wait another month for trade to become profitable.
Hedging a naked short put
When selling a naked put, the biggest negative is unlimited risk. This can be reduced or eliminated by buying a lower priced put. Hedging in this way limits the downside risk, but reduces total premium. Instead of a naked put, the seller would have a credit put spread. We’ll explore this extensively in later strategies.
Using a short naked put as a hedge
One way to use the sale of a put is to sell a put on a security that the seller has sold short. This is often referred to as a covered put. The put is covered by the underlying short shares in the account. If the shares go down and the option is exercised, the shares assigned to the seller will cancel out the short shares in the sellers account. Since the put was sold for a premium, the seller will make money even if shares are assigned to the account. While this is a viable strategy, it isn’t one I use. I’m not generally a fan of selling actual stock or other security shares short, because it involves borrowing shares to sell and most equities tend to increase in value.
