Understanding Call and Put Options
What is an option? An option is a contract written on an underlying investment vehicle. There are options on stocks, futures, indexes and exchange traded funds. We are going to focus on stock and ETF options. There are two types of option contracts, call and put. There are also two parties to each contract, the buyer of the option also known as the holder and the seller of the option who is also known as the writer. The holder of a call option has the right but not the obligation to purchase the underlying. The writer of a call has the obligation to sell the underlying. The holder of a put has the right to sell the underlying, while the writer of a put has the obligation to purchase the underlying. In market jargon if you buy an option you are considered to be long that option contract. Similarly if you sell an option you are considered to be short that option contract. If you sell and are short the option you can be either covered or uncovered. The market term for uncovered option positions is naked. So if you sell a call on a stock where you already own the underlying you are considered to be covered and that is known as a covered call. If you sell a call and do not own the underlying then you are short a naked call and the risk is potentially unlimited. Remember if you buy a call you have the right to buy the underlying stock at the strike price of your call contract. If you sell a call you are required to deliver the underlying stock at the strike price of the call contract. If you sell a naked call and the stock price rises dramatically due to a merger announcement or new product announcement the losses can be severe. If you have seen options literature that suggests you can have 90% winners that is the kind of risk they are taking on. There are always option contracts available that have a 90% probability of being out of the money at expiration. It’s the 10% that end up in the money that create substantial losses. Tactical option investors who use options to manage and enhance returns on stock and ETF portfolios control risk at all times. We do not use positions ever that have unlimited risk even if the probability of success is very high. When we employ option positions it is to enhance the performance of our portfolio and we are always aware of the risk we have at all times and only use option positions that have a defined risk. There are only two types of option contracts, call and put but they can be put together in numerous ways to create complex positions based on one’s outlook for the market. There are spreads, straddles, strangles, butterflies, condors and more. Later on we’ll discuss the various strategies, how they relate to market conditions and how they can be strategically employed along with an existing portfolio.