I’ve never considered myself an options expert. Not because I don’t understand them, but because I’ve never used them outside of a paper portfolio I traded through college and graduate school.
At the time, I wanted to understand how they worked because for some reason I felt drawn toward Wall Street, financial advising, or day-trading. In hindsight, none of these options seemed well-suited toward my long-term career ambitions and I’m grateful for moving down a more traditional finance route as an analyst.
However, I managed to study about options on the off chance I needed to secure a Series 7 license or even pursue the Chartered Financial Analyst designation. That knowledge stuck with me and I feel compelled to write about it here in greater depth.
Consider this an overview on how to trade options for beginners. I’ve included examples to illustrate these common options practices and hope to write more about this in the future.
Types of Stock Options
- Equity Options. These types of options are available on most listed and NASDAQ securities. Normally, stock options have a deliverable of 100 shares of the underlying security per contract. This means if you buy one call on Apple (AAPL), you have the right to purchase 100 shares of AAPL at an agreed upon strike price and expiration date (or before if an American-style option). Some higher dollar amount securities offer mini-options which make them sell in smaller denominations to yield a more liquid options market.
- Index Options. This option type differs from an equity option by settling in cash and typically with a multiplier of $100 per contract as opposed to an equity contract settling in 100 shares of stock.
As a note, the deliverable for an equity or an index option may change as a result of a stock split, reverse stock split, stock dividend, merger, or other action.
Options Contracts Strategies
When people consider options, the two most common strategies consist of purchasing a long call or long put.
The former allows the investor to buy a call and profit should the market price move north above the option’s strike price. The latter produces a positive return when the market price heads south below the option strike price.
Long Call Options
For the long call option, depending on the price movement of the underlying stock, the gains can represent significant capital appreciation.
This is because a 1% change in stock price does not necessarily represent a 1% gain in the option value.
Rather, if the investor forecasts the future stock price appreciation accurately, the percentage gains can be substantial relative to the original options investment. Specifically, the gains move in proportion to the option premium paid, not to the stock price itself.
For call buyers looking to lock in profits, they can wait for higher volatility like a market-moving event, major announcement positively-affecting the stock, or some other exogenous event.
During these moments, stock prices tend to fluctuate considerably as the markets attempt to find a new equilibrium price. These events present an opportunity for call option owners to sell the call option prior to expiration and recognize a gain on sale.
Depending on the duration of holding the option, these gains can qualify for short-term (1 year or less) or long-term capital gains (longer than 1 year).
Long Put Options
Likewise, long put option owners can take advantage of this same volatility to capture gains on downward stock price movements. Because exercising a put results in selling the underlying asset at a specific price (strike price), this presents a beneficial outcome when stock prices fall.
In effect, holding a long put yields a similar outcome as shorting a stock, though your losses are limited to the premium paid for the put option. For investors looking to capitalize on market volatility, selling the put option prior to expiration can produce positive results.
The key point of focus revolves around another type of risk discussed for call buyers as well: market-timing risk. Both financial instruments rely on timing your investment decisions and inherently expose the investor to added risk.
However, exercise good decision-making and you will find yourself rewarded. Now, let’s take a look at some other common options strategies investors use either to (1) hedge risk in their portfolio or (2) leverage returns in anticipation of stock price movements.
1. Covered Equity Options
The buyer of long options must pay 100% of the purchase price for equity options. The buyer will need cash or equity in the account at the time of placing the order and will be subject to 100% Regulation T and maintenance requirements.
- Writing a covered call means selling the right to another party to buy a security from you at a specific price on or before the expiration date (American vs. European-style). By establishing a short call position, the writer of the call option assumes an obligation to sell the underlying security if assigned on the options contract (counterparty forces the options contract).
If the call-option writer owns the underlying deliverable shares, then the options contract is “covered.” If assigned, the writer can deliver the shares instead of purchasing them on the open market.
Therefore, the covered call writer does not need to find additional funds whereas an uncovered call writer would. Stock serves as the backing for the call.
The underlying security for the covered call cannot have a higher value than the strike price of the short call for margin requirement purposes.
Motivation: Investor writing the call hopes the value of the stock deteriorates and can capitalize by collecting a premium from writing the call.
Maximum Gain: The premium collected from writing the call option.
Maximum Loss: Unlimited (stock could rise infinitely).
Breakeven: When the market price for the underlying stock is above the strike price in an amount equal to the premium received. In other words, when the intrinsic value of the option equals the price at which it was sold.
- Writing a cash-secured put means an investor creates an obligation to purchase the underlying security at the agreed-upon strike price on or before the expiration date. The put option writer assumes the obligation to purchase the underlying security if the options contracts become assigned.
The investor would choose to write a cash-secured put when at-the-money or out-of-the-money and simultaneously setting aside enough funds to buy the underlying stock.
If the put-options writer maintains a cash balance equal to the total exercise value of the contract, the put contracts become “cash-secured.” If the option is assigned, the put-options writer purchases the security with the cash which had been held to cover the put.
Motivation: This strategy’s primary goal aims to acquire stock for a price-sensitive investor. A cash-secured put writer wants to acquire the underlying stock through assignment. Specifically, the investor hopes to be assigned and acquire the stock below today’s market price. Regardless of assignment, all outcomes are acceptable and the investor will receive premium income to improve the net results.
Maximum Gain: Premium received.
Maximum Loss: Strike price – premium received (substantial).
Breakeven: Because the investor hopes to acquire stock in this options trading strategy, the break even would occur even if the investor could sell the stock at the same effective price paid. (Breakeven = strike price – premium)
- Writing a covered put involves creating an obligation to purchase the underlying security at the strike price on or before options expiration. The put writer assumes the obligation to purchase the underlying security if the options become assigned.
If the put-options writer has sold short the underlying deliverable shares and simultaneously written a put option, the put option is “covered.”
If the option is assigned, the put-option writer purchases the security and delivers it to the lending brokerage firm to “cover” the short equity position.
The short stock can never be valued lower, for margin requirement purposes, than the strike price of the short put.
To illustrate this strategy, suppose an investor wishes to short Google stock at $1,200/share and sells 100 shares short. At the same time, the investor sells $1,200 Google put options and collects $1,000 as a premium.
At expiration, Google stock remained at $1,200, leading to the maximum profit ($1,000). The $1,200 Google puts expire worthless while the investor covers the short position.
Now, imagine if Google’s stock had fallen to $1,100 on expiration. In this case, the short put expires in the money and is worth $10,000 (100 shares * $100/share decline) but the investor offsets this loss with the Google stock shorted (thus making this a covered put).
However, had Google’s stock rallied to $1,300, the investor experiences a significant loss.
At this stock price, the short stock position taken when Google traded at $1,200 suffers a $10,000 loss (100 shares * $100 stock appreciation) offset only by $1,000 in premium credit.
The investor recognizes a net $9,000 loss.
Motivation: The investor aims for the stock price to fall and covers partially against a stock price increase with a premium collected on writing the put option.
Maximum Gain: The premium received.
Maximum Loss: Unlimited.
Breakeven: When the market price of the underlying security equals the premium received.
2. Uncovered Equity Options
Before diving into uncovered equity options, it is important to state the greater inherent risk in these uncovered equity options than their “covered” counterparts. By pursuing an uncovered – or naked – options strategy, your risk for loss increases dramatically.
Commensurate with this added risk comes more stringent brokerage account requirements. Specifically an initial deposit in the brokerage account and stricter maintenance requirements.
An example of how some brokerages handle uncovered equity options includes a maintenance requirement of the highest of these three formulas:
- 20% of the underlying stock (or more, subject to brokerage firm requirements) less the out-of-the-money amount, if any, plus 100% of the current market value of the option(s).
- For calls, 10% of the market value of the underlying stock PLUS the premium value. For puts, 10% of the exercise value of the underlying stock PLUS the premium value.
- $50 per contract plus 100% of the premium.
To illustrate these three requirements, let’s look at an example.
In this example, the 20% maintenance requirement is used for uncovered equity options in this brokerage account ($8,500 > $5,250 > $1,500).
In this second example, the 10% maintenance requirement would be used ($4,000 > $3,500 > $750).
Brokerages maintain various minimum equity requirements on uncovered call and put options.
Some provide dollar value thresholds while also maintaining sufficient cash of marginable securities to cover the maximum potential loss in the case of uncovered equity put options.
Day traders should be aware of these limitations because brokerages track this activity closely.
3. Equity Spreads
We know what equities are – they represent a proportional share of ownership in a company or business endeavor.
“Spreads” are a position taken in two or more options contracts with the intent of profiting from or reducing the risk of loss from a sudden market shift in the underlying security or index.
An investor creates a spread position when buying and selling options of the same type (calls or puts) for the underlying security or index, which have different exercise prices and/or expiration dates.
- “Call Spread” – long call and a different short call on the same security or index.
- “Put Spread” – long put and a different sort put on the same underlying security.
In either case above, the short options must expire before, or at the same time as, the long options contract.
The simultaneous sale of the contracts results in a credit to the investor’s account ([$6.50 – $1.50] * 500 = $2,500). This occurs because more money comes to the investor from the sale of the calls than from the amount paid for buying the five calls.
Because the short side of the call contracts has a strike price lower than the long side, initial and maintenance requirements are computed as the difference between the strike price of the long and short options multiplied by the number of shares deliverable:
($70 – $60) * 500 = $5,000
For this spread position, the total requirement is $5,000. Due to the proceeds of $2,500 received in the transaction, an additional deposit of $5,500 is required to satisfy the margin requirement.
Options Strategies Summary
If this summary is your first exposure to options, I hope you keep an open mind about the role they can play in your portfolio.
Options are quite often seen as a dangerous financial instrument used only by the fat cats on Wall Street when they often serve much more benign and beneficial purposes.
In fact, positioning yourself wisely with options can reduce your risk exposure or leverage a speculative position in your portfolio. Alternatively, they can produce investment income in a market without incurring capital gains or losses taxes.
But most importantly and like anything in life, there are trade-offs when selling options. In return for the premium you collect, you are agreeing to a defined upside reward, but you also allow yourself more than one way to win.
Think about the examples we went through above. Depending on the movement of the underlying security price, you can make money if it goes up in value, stays the same, or if it goes down until it reaches your breakeven point.
Be cognizant of the risks and know this trade off can present a risk-weighted return worthwhile.