Buying a put gives you the right to sell the underlying stock at a set price (the strike price) by a specified date (the expiration date). Your maximum loss with a put is limited to what you pay for the option up front (the premium).

Buying put options is a great way to profit from a stock’s fall while putting less of your cash at risk. In addition, you can buy puts to protect a stock – one that you’re bullish on for the longer term – from a near-term price drop. Buying protective puts can also help make your portfolio immune to a market crash.

When you buy a put to protect a stock that you own, your maximum profit occurs through stock appreciation. In the best case scenario, your stock appreciates nicely, and your put expires worthless – essentially, the option premium you paid is like paying an insurance premium – and like insurance, that isn’t money wasted. What you purchased was peace of mind. Theoretically, your profit is unlimited because a long stock position’s profit is unlimited. But in practice, your profit will be reduced by the premium you pay.

A put has a firm expiration date, and unless the stock’s volatility greatly increases, the underlying put experiences “time decay” – a reduction in value with the passage of time. This means that unlike a short seller, as put buyers, we can’t just sit and wait around forever.

An options strategy’s break-even point is where the stock price needs to be at expiration for you to neither make nor lose any money. To break even when buying married puts, the stock just needs to appreciate by the amount of the option premium we paid. For example, a $50 stock would have to increase $11.20, to $61.20.

Why buy puts?

• You believe a stock is ripe for a fall and want to profit if it declines.
• You want to hedge against the bullish positions in your portfolio.
• You want to protect a position in your portfolio that you’re bullish on from a near-term downward move.

Which Put To Buy?

If buy a put to short a stock:

• The put should be on a business that (1) you know well, (2) you have good reason to believe is going to fall in price precipitously, and (3) has a downside catalyst that should help it achieve your fair value estimate prior to the option’s expiration date.
• When choosing an expiration date, make sure to allow enough time for your downside catalyst to pan out. These things sometimes take longer than expected, so it can be wise to use options that expire as far out as possible.
• To manage your risk, start off small. Your risk is limited to the premium you pay, but if you’re wrong, you will likely lose most if not all of the premium invested in most outcomes. Only purchase enough contracts to cover the same number of shares you’d be willing to short. For example, if you’d be shorting 300 shares, stick to just buying three puts.
• When it comes to strike prices, you have two choices: Buy an in-the-money put (usually 10% to 20% above the current share price) that will cost more, but is more likely to have value remaining at expiration. Or you can buy an out-of-the money put (with a strike price below the current share price) that will cost less, but that increases your odds of losing your whole investment if the stock doesn’t fall. Use whichever strategy you’re more comfortable with in each case.

If buy a put for stock protection:

• the put should be on a business you know well and have good reason to believe is worth much more. However, it has enough potential near-term risk that you also want protection while owning the stock.
• You must be willing to sacrifice the insurance premium in exchange for some extra peace of mind.
• When deciding on the strike price, you should do so based on (1) the stock’s valuation and the potential upside you see in the shares, (2) the amount of possible risk you see in the shares, and (3) the amount you’re willing to comfortably spend for protection (which will relate in part to the upside you’re trying to capture and the downside you’re exposed to).
• When choosing an expiration date, think in terms of purchasing insurance. Buy protection that covers enough time that will make you feel comfortable, but make sure you double-check the break-even point to make sure that there is enough upside for the overall investment to still be attractive.

Buying puts is the most direct option strategy to potentially profit on a stock you believe is ripe for a sizable decline. The strategy works best if you expect the stock to fall far within a defined time frame. Buying puts can reward you with significant upside while greatly limiting your downside compared with just shorting a stock outright. Buying puts to protect your stock is a good strategy to help you sleep at night when you don’t mind paying extra for some peace of mind. This strategy can reward you by protecting you from the downside risks while still maintaining the attractive return characteristics of investing in common stocks.

Follow the practical way,
George Traganidas

Buying call options is a lot like purchasing stock: You believe that a company you understand well will grow in value over a certain period of time, and you want to generate a profit from it. When you buy a call, you have the right to buy the underlying stock at a set price (the strike price) by a specified date (the expiration date). If the stock price goes up, the value of its calls will too.

In theory, there’s no limit to how high a stock price can go — and in turn, call options can have unlimited profit potential.

When purchasing an option, your maximum loss is limited to the premium you’ve paid. It usually makes sense to exit a losing position before the expiration date in order preserve some capital, but sometimes an option loses so much value that selling it makes little sense. To be safe, you need to be prepared to accept a full loss.

An options strategy’s break-even point is where the stock price needs to be at expiration for you to neither make nor lose any money. When you buy a call, the break-even point is the strike price plus the premium you paid. For example, if the strike price is $30 and the premium is $5.80, your break-even price would be $35.80 (strike price + premium).

Why buy calls?

• You believe a stock has a strong catalyst for appreciation over the coming months or few years.
• You want to benefit from a stock’s upside, but put less capital at risk than buying the stock outright.
• You want to leverage your bullish expectations on a stock you already own.

Which Call To Buy?

• The option should be on a business that (1) you know well, (2) you have good reason to believe is worth much more than its current stock price, and (3) has a catalyst that should help the stock reach your fair value estimate prior to the option’s expiration date.
• When choosing an expiration date, make sure to allow enough time for your catalyst to pan out. These things sometimes take longer than expected, so it can be wise to use options that expire as far out as possible.
• Don’t overleverage – you’ll be risking a very large loss. Only purchase enough contracts to cover the same number of shares you’d be purchasing as a long stock position. For example, if you’d be purchasing 300 shares, stick to just buying three contracts. This will cost significantly less money than a stock purchase.
• When it comes to strike prices, you have two choices: Buy a deep in-the-money call (meaning the strike price is well below the stock price — at the very least, 10%) that will cost more, but that lets you more easily convert the calls to stock if you need more for your catalyst to play out. Or you can buy an out-of-the money call that will cost less, but that increases your odds of losing your whole investment if the stock doesn’t increase above the strike price.

Buying calls is a straightforward option strategy that lets you leverage a bullish stock idea, in a shorter period of time, while putting less capital at risk than buying the stock outright. The strategy works best if you expect the stock to go up within a defined time frame. You have unlimited upside when you buy calls; however, as with any option purchase, if it works against you, must be prepared to lose what you paid for the options.

Follow the practical way,
George Traganidas

American style: Options contracts that can be exercised at any time after purchase and before the expiration date.

Assignment: When the options writer (also called the seller) is forced to buy (for a put writer) or sell (for a call writer) the underlying stock. Essentially, your counterparty has exercised its option contract, which you wrote, to buy or sell the underlying stock.

At-the-money: An option whose underlying stock is trading at its strike price.

Bearish: An options strategy (and outlook) that achieves its maximum payoff when the underlying stock drops in price. For example, if you are bearish on a stock you know well, you could buy a put or a bear put spread.

Binomial Model: An options pricing model that’s useful for American-style options because it can help predict those rare occasions when early exercise is possible. It uses an iterative process that allows for pricing options at different points prior to expiration.

Black-Scholes Model: The most well-known options pricing model. It’s used for pricing European-style options, though it still provides a useful approximation of American-style option values, as long as the investor is aware of the model’s limitations.

Break-even point: The price the underlying stock needs to reach at expiration for an option investor to neither make nor lose any money. In strategies involving more than one option, there can be more than one break-even point.

Bullish: An options strategy (and outlook) that achieves its maximum payoff when the underlying stock appreciates in price. For example, if you are bullish on a stock you know well, you could buy a call or a bull call spread.

Buy to close: The brokerage command to exit an option contract in which you originally wrote (“sold to open”) the put or call.

Buy to open: The brokerage command to enter an option contract in which you intend to buy a put or call.

Call option: The right, but not the obligation, to buy the underlying stock at a set price (the strike price) at or before the option’s expiration date. A call rises in value as the stock price rises and declines in value when the stock price falls.

Close: Exit an option contract. See also “buy to close” and “sell to close.”

Contract: Each standard option contract represents 100 shares of the underlying stock, provided no splits or other adjustments (i.e., corporate mergers) take place. A contract is quoted at the price for one share, so multiply by 100 to get the full contract value. For example, buying two option contracts for $1.50 actually represents 200 (2 x 100) shares of stock and would therefore cost $300 ($1.50 x 200).

Delta: One of the five “options Greeks” (delta, gamma, rho, theta, and vega), this indicates an option’s sensitivity to changes in the underlying stock price. A call option with a delta of 0.6 tells you that the option’s value will increase $0.60 for every $1 move in the stock price. Since the option is less expensive than the stock, the $0.60 increase represents a greater percentage change for the option than the $1 change in the stock.

European style: Option contracts that can only be exercised at expiration.

Exercise: Invoking the right (as granted by the option contract) to buy (if a call) or sell (if a put) shares of stock at the strike price.

Exercise price: See “strike price.”

Expiration date: The date on which the option contract becomes void, and the option holder no longer has the right to buy or sell stock granted by the option.

Gamma: One of the five “options Greeks” (delta, gamma, rho, theta, and vega), this shows how fast delta changes with respect to the underlying stock price. The larger the gamma, the faster delta changes; gamma is maximized when the stock price equals the option’s strike price.

Greeks: This refers to delta, gamma, rho, theta, and vega, risk measurements used to monitor the sensitivity of an option’s price with respect to a change in one of the underlying contributors to option valuation — stock price, volatility, time-to-maturity, and interest rates.

Hedge: An offsetting position meant to reduce the price volatility or risk of an investment.

Implied volatility: A prediction of the volatility of an underlying stock; it’s calculated using the current market trading price of the option. Implied volatility may or may not bear any resemblance to actual historical volatility. See also “volatility.”

In-the-money: Indicates that an option has intrinsic value. Calls are in-the-money when the underlying stock is above the option’s strike price (a stock is at $22 and the call has a strike price of $14, allowing the holder to buy the stock at $14). Puts are in-the-money when the underlying stock is below the option’s strike price (a stock is at $22 and the put has a strike price of $30, allowing the holder to sell the stock at $30).

Intrinsic value: An option’s value if it were to expire immediately; i.e., the value in direct proportion to the underlying stock’s current price. For calls, intrinsic value is the current stock price minus the strike price. For puts, intrinsic value is the strike price minus the current stock price.

Last trading day: The final day where trading takes place on an option contract prior to the settling of the contact, usually the third Friday of the expiration month.

LEAPS (Long-Term Equity Appreciation Securities): Options that, when first offered, expire at least two years in the future. Most new LEAPS become available between September and November, depending on which option cycle the underlying company is on. We like LEAPS because they provide longer-term choices for an investment thesis to play out.

Leg: One piece of multi-option strategy. It also refers to entering or exiting a multi-option strategy (“leg in” or “leg out”) at disparate times and prices chosen to benefit the intended strategy, but with the potential risk that better prices will never be available.

Limit order: A modification to a brokerage command to buy or sell that allows you to buy or sell at a set price or better. These are particularly useful for illiquid stocks, as well as the option markets, for
which there is often limited liquidity.

Naked: Also known as “uncovered”, a naked position is one taken by an option writer (also know as the seller) who doesn’t have a corresponding position in the underlying stock. Some naked strategies — writing calls on rocket-ship growth stocks, for example — are very risky, as they expose you to potentially unlimited losses.

Neutral: An options strategy (and outlook) that achieves its maximum payoff when the underlying stock doesn’t change in price.

Open: Refers to entering an option contract. See also “buy to open” and “sell to open.”

Open interest: The total outstanding open contracts on any particular option. If you buy or sell to open, you’ve just upped the open interest. If you buy or sell to close, you’ve just decreased it.

Option cycle: Expiration dates available for various classes of options. There are three cycles, offset monthly: January/April/July/October; February/May/August/November; and March/June/September/December.

Out-of-the-money: The opposite condition to being in-the-money. Here, an option has no intrinsic value, only time value. For example, if a stock is trading at $8, its call options with a $10 strike price would be out-of-the-money.

Premium: The total price of an option contract; the sum of an option’s intrinsic value and its time value.

Put option: The right, but not the obligation, to sell a stock at a set price at or before the expiration date. A put’s value increases as a stock’s price falls.

Rho: One of the five “options Greeks” (delta, gamma, rho, theta, and vega), this indicates an option’s sensitivity to changes in short-term interest rates. Option premiums get more expensive when interest rates go up.

Rolling forward, up, or down: Follow-up action in which you repurchase or sell an option you already own while changing the strike price, expiration date, or both. “Rolling forward” (also called “rolling out”) involves closing options that expire in the near term and opening options with longer-term expirations. “Rolling up” involves closing options with a lower strike price and simultaneously opening new options at a higher strike price (while maintaining the same expiration). “Rolling down” involves closing options at a higher strike price and simultaneously opening new options at a lower strike price.

Sell to close: The brokerage command to exit an option contract in which you originally bought (“buy to open”) the put or call.

Sell to open: The brokerage command to enter an option contract in which you intend to write (a.k.a. sell) a put or call.

Spread: Any option strategy in which you buy and write (“sell to open”) options of the same type (call or put) on the same underlying stock.

Straddle: A direction-neutral options strategy consisting of a call and a put with the same strike prices and expiration date. It profits from a large move, up or down, in the underlying stock.

Strangle: Similar to a straddle (a strategy consisting of a call and a put with the same expiration) but with different strike prices. It profits from large moves, up or down, in the underlying stock. A strangle is cheaper to set up than a straddle but requires a larger move in the underlying stock to become profitable.

Strike price: Also known as the “exercise price,” this is the price at which the option holder can buy (in the case of a call) or sell (in the case of a put) the underlying stock.

Synthetic: A way of using options, sometimes in conjunction with long or short positions in the underlying stock, to mirror the profit and loss potential of a different position. For example, a synthetic long can be created by buying a call and selling a put with the same expiration dates and strike prices. The profit payoff on such a strategy is identical to that of simply buying the underlying stock at the strike price; however, the cost to establish the position is considerably less.

Theta: One of the five “options Greeks” (delta, gamma, rho, theta, and vega), this measures an option’s sensitivity to time, or how much the option price decays per day.

Time decay: The reduction in an options value through the passage of time. See also “Theta.”

Time value: The premium that the market is willing to pay for the potential upside of the option until expiration. Its value accounts for beneficial unknowns and volatility until expiration. For a tradable option, deduct intrinsic value from the trading price to arrive at time value. Options are wasting assets, meaning time value declines as expiration draws closer. See also “time decay.”

Uncovered: See “naked.”

Underlying stock/security: The stock being bought or sold at the expiration of the option contract. Since stocks are pieces of businesses, it makes sense to understand that business, its valuation, and its prospects before overlaying options strategies on them.

Vega: One of the five “options Greeks” (delta, gamma, rho, theta, and vega), this indicates an option’s price sensitivity to a change in volatility. Higher volatility makes options premiums more expensive.

Volatility: An estimate of the amount that the underlying stock’s price is expected to fluctuate in a given period of time. Generally, volatility is measured by the standard deviation of the continuously compounded returns of the underlying stock.

Write: To sell an option contract. We prefer to use “write” when referring to selling an option contract in general, but specifically this refers to selling a new option contract. The option seller is referred to as the option writer.

Why Options?

Options are excellent tools for generating income, protecting profits, hedging, and, ultimately, earning outsized gains. They can generate returns in flat markets, cushion the blow of down markets, and be outstanding performers in decent markets. Whatever your investment goals, options can be a powerful addition to your portfolio, used to hedge, to short, to produce income, and to obtain better buy and sell prices.

What Are Options?

Stock options formally debuted on the Chicago Board Options Exchange in 1973, although option contracts (the right to buy or sell something in the future) have been around for thousands of years. An option gives the holder the right, but not the obligation, to buy or sell an underlying stock at a set price (the strike price) by a set date (the expiration date). The option contract allows you to profit if a stock moves in your favor before the contract expires. Not all stocks have options, only those with enough interest and volume. There are only two types of options: calls and puts. A call appreciates when the underlying stock rises, so you buy a call if you are bullish on that company. A put appreciates when a stock declines. You buy a put if you believe a stock will fall or to hedge a stock that you already own.

Buying Calls

Investors often buy call options rather than buying a stock outright to obtain leverage and potentially increase returns several-fold. Call options work as “controlled” leverage, enhancing your possible returns while limiting your potential losses to only what you invest. Because each option contract represents 100 shares of stock, an investor can control many shares of stock without putting a lot of capital at risk.

Imagine that a stock that you know well has declined in value and now trades at $27 per share. You believe the shares will rebound in the coming months or year. The market offers $30 call options on the stock that expire in 18 months for $1.50 per share. Therefore, 10 contracts, representing 1,000 shares of the stock, will cost you $1,500 plus commissions. This option contract gives you, its owner, the right to buy 1,000 shares of the stock at $30 any time before expiration. A few things could happen here:

a) If your stock starts to rise again, your options will increase in value, too. Suppose the stock recovers all the way to $32 after a few months. Your option’s value would likely at least double to $3 or higher per contract. You’ve made 100% in a few months. If you had simply bought the stock, you’d only be up 18.5%.

b) If your stock continues its decline. Even 18 months later, it’s below $20, so your options expire worthless (unless you sold them at some point along the way to recoup part of your investment).

Buying Puts

You buy put options when you believe that the underlying stock will decline in value. Buying puts is an excellent tool for betting against highly priced or troubled stocks, or even entire sectors. With put buying, your risk is again limited to the amount that you invest in stark comparison to traditional short selling, where your potential losses are unlimited. Aside from betting against a position with puts, you may also buy puts to protect an important position in your portfolio, one that you do not want to sell yet for any number of reasons. When a stock being protected (or hedged) in this way declines for a while, the puts will increase in value, smoothing out returns.

Selling Covered Calls

“Covered” simply means that you own the underlying stock at the same time. Writing covered calls is one of the most conservative options strategies available. In fact, most retirement accounts allow you to write covered calls. They’re generally used to generate income on stock positions while waiting for a higher share price at which to sell the stock.

Suppose you own 1,000 shares of a stable, blue-chip stock. It’s trading at $56, but you think it is fairly valued around $60 and you would be happy to sell at that price. So you write $60 call options on the stock expiring a few months ahead, and you get paid up front to do so. A few things could happen here:

a) If the stock does not exceed $60 by your option’s expiration, you keep your shares and you’ve made money on the call options. You could then write more calls if you wanted to.

b) If the stock is above $60 by expiration and you haven’t closed out your call option contract, you’d sell your stock at $60 via the options.

Write covered calls when:

• You would sell a stock that you own at a higher price, and you’re not worried about it declining too much in the meantime.
• You believe a stock you own is going to stagnate for a while, but you don’t want to sell it right now. Write calls to make the stagnation more profitable.
• You want to cushion a stock that is in decline, but that you’re not ready to sell yet. Tread carefully here so you don’t get sold out at too low a price.

When you write covered calls, you must be prepared to give up your shares at the strike price. Approximately 80% to 90% of options are not exercised until expiration, but they can be exercised early, so the call writer has to be prepared to deliver the shares at any moment.
That means that if the $56 stock in the example above suddenly soars to $70, you’d still have to sell at $60. This is the biggest downside to covered calls — lost potential if a stock price rises. The other risk is that a stock may fall sharply after hovering around your desired sell price for a while, forcing you to wait longer for your sell price.

Selling Puts

Put options are an excellent way to potentially buy a stock at your desired, lower share price and get paid an option premium while waiting for that price, whether it arrives or not.
A stock is trading at $39 and your analysis suggests that you should not buy it above $35. The $35 put options expiring four months out are paying $3 per share. You “sell to open” the put contracts and get paid $3 per share to make the trade, giving you a potential net purchase price of $32 before commissions. A few things could happen here:

a) If the stock stays above your $35 strike price; the options you sold would expire. You didn’t get to buy the stock at the price you wanted, but at least you made money on the options you sold.

b) If the stock falls below $35 by expiration. In this situation, your broker would automatically buy the stock for your account, giving you a start price of $32 before commissions.

Writing puts on stocks you know well and want to own at lower prices can be an excellent tool for income and for securing lower buy prices, but you must be prepared to buy the stock should it fall below your strike price. At all times, you must maintain the cash or margin to buy shares if they are put to you. It’s important that you only write puts on stocks that you understand well and will be happy and ready to buy at the prices you’re targeting. The risks of writing puts include the fact that the stock could soar away without you. In many cases, it’s better to just buy a great stock once you’ve found it. The other risk, of course, is that a stock falls sharply and you’re stuck owning it. The biggest risk with selling puts, as with all options, is when investors rely on margin instead of cash. That can quickly wipe out a portfolio.

Follow the practical way,
George Traganidas