Calls and puts are options that give you the right, but not the obligation, to buy or sell stocks. They can be used to hedge risk in your portfolio when used properly. Each option gives you the right to buy/sell 100 stocks. Thus, 1 option = the right to buy/sell 100 shares.
Almost every brokerage, including TD Ameritrade, Charles Schwab, Fidelity, Etrade, and others will require you to apply for options trading permission. You can find out more information about options trading permission here. If you’re a safe investor looking for long term gains, I wouldn’t advise anything higher than Level 2 Risk Level. Like all financial instruments, options do have risk and speculation and I wouldn’t use them if you’re not comfortable losing money in your portfolio.
But before you apply for permission to trade options, you need to know what they are! Here are some basic terms you will need to know. Feel free to skip them if you’re familiar with finance terms already.
Defined Terms:
Option price: How much the option costs. If you’re selling an option, you receive payment equal to the price. If you’re buying an option, you’re paying the seller the price.
Long: if you are long an option, you purchased the option and paid a seller the option price.
Short: if you are short an option, you sold (aka wrote) the option to a buyer and they paid you the option price.
The strike price is the threshold price that the buyer and seller agree upon. It’s also the price used to determine whether people exercise their option (aka whether .
Long calls are “in the money” when the current price of the stock rises above the strike price.
Long puts activate when the current price of the stock falls below the strike price. We call this activation “in the money.”
Exercising a stock: you used your right as an option holder to buy/sell your stocks. You would want to do this only if your option is in the money.
You can either be long (a buyer of) or short (a seller of) an option.
Being Long/Buying An Option
When you buy an option, that means you are long the call/put. This means you are the buyer, and you paid someone else the price of the option. If you are long and the option becomes in the money, then you would exercise your option and you would make a profit. The person who sold you the option would make a loss. If your option never moves into the money then you would never exercise your option and it would expire. You lose the amount you paid to the seller, but nothing more.
Long Call Options
A call option is the right to buy stock at a predetermined price (aka the strike price) any time before a predetermined date (aka the expiration date).
The call option cost $200. The strike price is $40. The call is in the money when the price of the stock rises past $40. If you exercise the call, you have the right to buy 100 shares of the underlying stock at $40 per share.
Long Put Options
A put option is the right to sell stock at a predetermined price (aka the strike price) any time before a predetermined date (aka the expiration date).
The put option cost $200. The strike price is $40. The put is in the money when the price of the stock rises falls $40. If you exercise the put, you have the right to sell 100 shares of the underlying stock at $40 per share.
Being Short/Selling An Option
If you sell an option, that means you are short/wrote an option. Someone else paid you money and you wrote them an option in return. If you are short and the option you wrote becomes in the money, the buyer would exercise your option against you and you would be forced to honor it. If you sold a call, then that means you have to sell 100 shares of stock to the buyer at the strike price. If you sold a put, then you have to buy 100 shares of the buyer’s stock at the strike price. As a seller, you hope that the option you wrote never gets exercised and you get to keep the money you made from selling the option. Unless you have something else hedging your investment or you’re a professional trader, shorting options is risky because you have unlimited loss potential and limited upside potential.
The one large exception to this is covered calls. If you own at least 100 shares of a company’s stock in your portfolio, you can sell/write covered calls for some additional income. This is what a covered call’s payoff looks like:
If you own the stock, then your risk is mitigated:
- If the stock price rises but is still below the strike price, then the buyer does not exercise their call. You keep the money from selling the option AND your stock rose in value.
- If the stock price rises above the strike price, the buyer exercises their call. You keep the money from selling the option but you have to sell them your stock.
- If the stock price falls, the buyer does not exercise their call. You keep the money from selling the option but your stock dropped in value.
These are the basics of puts and calls. If you’re doing anything other than going long (buying) a call, it can be risky! There’s a lot of potential to lose money – just look at Tesla’s 2020 short squeeze as an example. Although they are a way to help you hedge risk, there are still many ways to lose money when trading options, so do your research and trade carefully!