The Ins and Outs of Puts and Calls

By: John Weston and Chuck Hughes

The following is an excerpt from John Weston and Chuck Hughes'  The Complete Guide to Becoming a Shoestring Millionaire

In my experience, investing in options has been one of the most versatile and rewarding approaches to profitable investing.  Option investing enables many different types of investors to achieve their specific investment goals.  I have traded many types of option strategies with different investment goals.  I favor the four option strategies listed below as I have had good success trading these strategies.

1. Purchase options to realize trading profits
   
2. Construct an option spread that can profit during an up or down market
3. Sell option premium to produce income
   
4. An option strategy that protects your stocks from price declines by using dividends to purchase an 'insurance policy' that limits your risk

Important Note:  It is important to note that if you trade the strategies presented in this article, your risk is strictly limited and you can't lose more money than you invest.  This is different than trading Forex or futures contracts which can result in a total loss of your account balance and which can force you to receive margin calls that can far exceed the total value of your trading account.

Learning the mechanics of option investing can be a bit overwhelming particularly if you have never invested in options before.  Let's start with the basics.  Options are contracts.  The terms of option contracts are standardized and give the buyer the right to buy or sell the underlying stock at a fixed price which is known as the 'strike price'.  Option contracts are valid for a specific period of time which ends on option expiration day.  All options contracts traded on the U.S. Securities Exchanges are issued, guaranteed and cleared by the Options Clearing Corporation (OCC).  The OCC is a registered clearing corporation with the Securities and Exchange Commission (SEC) and has received an 'AAA' credit rating from Standard & Poors Corporation for its ability to fulfill its obligations as counter-party for option trades.

There are two types of options; calls and puts.  Simply stated a call option is a contract that gives you the right to buy a stock at a specified price which is called the 'strike price' on or before the expiration date of the option.  A put option is a contract that gives you the right to sell a stock at a specified price called the 'strike price' on or before the expiration date of the option.

There are two ways to invest in options:
1) Buying options
2) Selling options

Buying Options
The goal of buying an option is to 'Buy Low and Sell High'.  Buying a call option is a bullish strategy as the value of a call option will increase as the price of the underlying stock increases.  Conversely, if the price of the underlying stock decreases then the value of a call option also decreases.

Buying a put option is a bearish strategy as the value of a put option will increase as the price of the underlying stock decreases.  Conversely, if the price of the underlying stock increases then the value of a put option will decrease.

The price you pay for an option is called the premium.  When you buy an option, cash is deducted from your brokerage account to pay for the option premium.  One option contract normally controls one hundred shares of the underlying stock.  Purchasing an option with a 4.00 point premium would result in $400 being deducted from your brokerage account to pay for the premium (4.00 x 100 shares = $400).  If you later sold this option for 6.00 points you would realize a $200 profit.

Buy at 4.00 and sell at 6.00 = 2.00 Profit

Conversely, if you later sell this option for 3.00 points you would realize a $100 loss.

Buy at 4.00 and sell at 3.00 = 1.00 Loss

Note:  When you buy an option, you can sell the option any time prior to option expiration.

Selling Options

The goal of selling an option is to 'Sell High and Buy Low'.  When you sell an option, cash is credited to your brokerage account.  For example, if you sell an option for 6.00 points, $600 will be credited to your account ($6.00 x 100 shares = $600).  This is just the opposite of purchasing an option.  As noted previously, buying an option for 6.00 points would result in $600 being deducted from your account.

Selling a call option is a bearish strategy.  An investor who sells a call option is also known as the 'writer'.  Selling a call is also known as being 'short' a call.  The value of a call option declines as the underlying stock decreases in price.  Being 'short' a call option generates profits as the call option decreases in value.

If you sell a call option and the call option subsequently decreases in price then you can 'buy back' the short call at a lower price which will result in a profit for the call writer (sell high and buy low).  For example, if you sell a call option for 5.00 points and then later buy the call back for 3.00 points you would realize a 2.00 point profit.

Sell call at 5.00 and then buy back at 3.00 = 2.00 profit

This is a similar concept to 'shorting' a stock.  If you short a stock that drops in price and then subsequently buy the stock back at a lower price you would realize a profit.  For example, if you short Apple stock (AAPL) at 74.25 and subsequently buy the stock back at 70.00 you would realize a 4.25 point profit.

Sell Apple stock at 74.25 and buy back at 70.00 = 4.25 profit

If you sell a call option for 5.00 points and then later buy the call back at a higher price let's say 7.00 you would realize a 2.00 point loss.

Sell call at 5.00 and then buy back at 7.00 = 2.00 loss

Selling a put option is a bullish strategy.  An investor who sells a put option is also known as the 'writer'.  Selling a put is also known as being 'short' a put.  The value of a put option declines as the underlying stock increases in price then you can 'buy back' the short put at a lower price which will result in a profit for the put writer.  For example, if you sell a put option for 5.00 points and then later buy the put back for 3.00 points you would realize a 2.00 point profit.

Sell put at 5.00 and then buy back at 3.00 = 2.00 profit

If you sell a put option for 5.00 points and then later buy the put back at a higher price let's say 7.00 points you would realize a 2.00 point loss.

Sell put at 5.00 and then buy back at 7.00 = 2.00 loss

Let's review the types of option orders that you would give to your broker (or online) to make sure you understand this important concept.