Option Building Blocks

Calls and Puts

Recall from our What Are Options key, that an option is a contract between a buyer and a seller. In our real estate example, Jennifer and Bill helped us explain a Call option. Remember that a Call option is a bullish option. In other words, the buyer of a Call option believes the underlying asset will increase in value. In the case of stock options, that underlying asset is a stock.

Therefore a Call option buyer has…

the right, but not the obligation
to buy a stock
at a fixed price
before a predetermined date.

And likewise, a Call option seller has…

the obligation (if the buyer chooses to exercise his/her right to purchase)
to sell a stock
at a fixed price
before a predetermined date

As we saw in our What Are Options key, the option buyer and seller typically have opposite points of view with regard to the market value of the underlying asset before the expiration date of the option. For example, Bill suspected the price of his house to either remain the same or even move down slightly before the expiration date of the Call option he sold. Jennifer on the other hand believed that the price of Bill’s house would increase substantially before the expiration of the Call option she purchased from Bill.

The same holds true for options on stocks. Let’s look at the following example of a Call option on a stock to demonstrate the opposing views of a potential buyer and seller.

Example – Buyers vs. Sellers of Call Options

Possible Seller’s Outlook

John, a retired engineer, purchased 100 shares of stock in a large department store chain several years ago. His stock has increased in value nicely in the last few years, but he feels that consumer spending is getting weak and that department stores might not do well in the near term. He believes that in the next 6 months the market value of his stock will either remain at current prices or perhaps even decrease slightly. At this point Bill begins to consider selling his stock to lock in his gains. John’s dilemma however, is that he doesn’t really want to part with his stock because he believes over the long-term it will continue to rise in value, providing him with even greater returns. He also wants to postpone any capital gains taxes from the sale of his stock. Therefore, John decides to sell a Call option with an expiration date six months from now. Because he believes his stock will not increase in value, John sells a Call option with a strike price slightly higher than the stock’s current price. His expectation is that this Call option will expire worthless and that he will keep the premium from the sale of the Call option.

Possible Buyer’s Outlook

Meanwhile Molly, a store manager at a local department store, has seen very strong sales in her own store lately. Contrary to John’s opinion, she believes that consumer spending is strong and that department stores will continue to increase their sales in the next 6 months. Because she is so familiar with department stores, and because she believes they will continue to do well in the near term, Molly determines that investing in the retail sector would be the best fit for her. Consequently the stock that she picks for her investment happens to be the same one that John owns and has the stock ticker symbol XYZ. But because Molly is an informed investor, aware of the power of options, she decides to buy a Call option on XYZ stock in order to maximize her gains on a strong move up in the stock while limiting her risk in case she is wrong.

Note: In John’s case, his risk is limited when selling an option on stock he already owns. If XYZ stock increases in value to a point greater than John’s strike price, the buyer of a Call option on his stock will likely exercise their right to purchase his stock and he will be obligated to sell it at the strike price of the option. This isn’t a problem for John because at this higher price he will still be selling his shares at a profit. But what if John never owned XYZ stock to begin with? Could he still have sold a Call option on it? The answer is yes. But without owning the stock to cover his position, John’s risk would be unlimited! In other words, if the Call option buyer decided to exercise their right to buy XYZ from John and he did not already own the stock, he would have to go out into the market and purchase it for a higher price and then immediately sell it back to the option’s owner at a loss. The higher the stock moves, the bigger his potential loss. In options trading, selling an option without owning the underlying asset is called selling naked.

Call Options and Market Sentiment

Thus far we have learned that if we are bullish on a stock we want to buy call options, and if we are bearish on a stock we want to sell call options.

BUT… remember that option buyers have limited risk. However, naked option sellers have unlimited risk!

So is there a way to be bearish and have limited risk?

YES… buy a Put Option.

Put Option Definition

A Put option is a bearish option. In other words, the buyer of a Put option believes the underlying asset will decrease in value. In the case of stock options, that underlying asset is a stock.

Therefore a Put option buyer has…

the right, but not the obligation
to sell a stock
at a fixed price
before a predetermined date.

And likewise, a Put option seller has…

the obligation (if the buyer chooses to exercise his/her right to sell)
to buy a stock
at a fixed price
before a predetermined date

Basic Put Option Terms

Strike Price: Price at which you have the right to sell the underlying asset

Option Premium: The price of the option (contract) that you purchase

Expiration Date: The date at which the option contract (and the buyer’s right to exercise their option) expires

Exercising a Put Option: Selling the asset to the option seller at the strike price on or before the expiration date

Breakeven: The value that the asset must reach for your option to become profitable

Put Option Example

Let’s look at a Put option for a fictitious stock with ticker symbol ZZZ that is currently trading at $50. We think that the price of the stock will fall below its current level before January 2005.

Remember that when we believe a stock will decrease in value and we want limited risk we want to purchase Put options.

Looking at option price quotes you might see a Put option with a strike price of $50 selling for a premium of $2.50 per contract with an expiration of January 2005.

Strike Price: $50

Premium: $2.50

Expiration: January 2005

The standard method of describing this option would be “ZZZ Jan05 50 PUT”

Buying this Put option gives you the right, but not the obligation, to sell 100 shares of ZZZ stock for $50 per share before expiration in January 2005.

Note: One options contract typically covers 100 shares of stock. In other words, when you purchase one option contract you have the right to buy (or sell) 100 shares of the underlying stock. Therefore, even though you will see option prices quoted in dollars and cents, your actual cost will be 100 times that. In example, the ZZZ Jan05 50 PUT above has a premium of $2.50, but it will actually cost you $250 to purchase. ($2.50 x 100 shares of ZZZ = $250)

Results at Expiration of a Put Option

Below are three possible scenarios that may occur at the expiration of your ZZZ Jan05 50 PUT option contract in January 2005:

1) ZZZ is now worth $40 per share.

You exercise your option by buying 100 shares of ZZZ for $4,000 ($40 per share x 100 shares) and then immediately selling those 100 shares to the Put option seller at the strike price of $50 per share. The sale will generate $5,000 ($50 per share x 100 shares). At this point you have made a profit of $750. ($5,000 from sale of 100 shares - $4,000 cost of purchasing 100 shares - $250 option premium)

2) ZZZ is now worth $47.50 per share.

You exercise your option by buying 100 shares of ZZZ for $4,750 ($47.50 per share x 100 shares) and then immediately selling those shares to the Put option seller at the strike price of $50 per share. The sale will generate $5,000 ($50 per share x 100 shares). At this point you have broken even. ($5,000 from sale of 100 shares - $4,750 cost of purchasing 100 shares - $250 option premium)

3) ZZZ is now worth $60 per share.

Because the market value of ZZZ is now greater than $47.50 per share (your breakeven point) you will not exercise your option and will therefore, let your Put option expire worthless since you could sell shares of ZZZ on the open market for more than $50 per share. At this point you have lost the $250 premium you paid for your Put option.

Call/Put Options and Market Sentiment

Remember that option buyers have limited risk. Naked option sellers have unlimited risk!

Therefore if we are bullish we would typically want to buy call options, and if we are bearish we would typically want to buy put options.

Congratulations! You now know more about trading options than the majority of investors in the market. Check out our Power of Leverage key to learn how you can use calls and puts to supercharge your portfolio.