Basic Call and Put Options Strategies

A call option gives its owner the right, but not the obligation, to buy the underlying security at a specific price (the strike or exercise price) on or before a specific date (the expiration). A put option gives its owner the right, but not the obligation, to sell the underlying security, again, at a specific price on or before a specific date. 

For standard, American-style equity options, each contract represents 100 shares of stock and may be exercised or assigned at any time up to and including the expiration date. (Non-standard and index options may have different deliverable specifications, so it's important to understand the terms before trading.) Contracts are priced per share, so traders need to multiply an options contract's quoted price by 100 to determine the price of a single contract. For example, a call priced at $3.50 would cost the option buyer $350, but the premium paid for an option is typically a fraction of the underlying asset's price. 

Two common call options strategies are buying calls as a stock alternative and selling calls against shares of stock owned to generate income. 

Buying a call option is often considered a bullish strategy because the price of the call option typically rises along with the price of the underlying security. Similarly, call prices typically fall when the underlying security falls. Traders or investors who have a directional view might consider buying a call option as a lower-cost alternative to buying a stock outright. 

It's important to remember that unlike stocks, options have an expiration date. If a trader buys an option and it expires worthless, they lose their entire investment and don't have unlimited time to hope for a recovery. Additionally, options don't carry voting rights, and they don't pay dividends. 

For example, a trader who is bullish on a stock could buy shares or an option. Shares are $188 each. The trader could also buy call options at a strike price of $200 for $2.69 per option. Because options trade in units of $100, the options position costs $269 versus $18,800 to buy 100 shares. 

If the stock price declines, the option price will also typically decline. If held until expiration, they'll expire worthless. If the stock increases, the option price will also increase, at which point the trader could sell it at a profit or hold it to see if it goes in the money (ITM), meaning the stock moves above the strike price of $200. 

If the share price exceeds $202.69 ($200 exercise price plus the $2.69 options premium), then the options trade is profitable. At this point, the trader could close the options trade and collect a profit or exercise their right to purchase the shares at $200 each, which at this point would be a discount to the market price. Because options require less upfront capital but still participate in the underlying's price activity, they are often used by speculators who have no real interest in owning shares of the stock itself. 

Some option traders turn to call options when they already own the stock. Instead of using calls as a lower-cost substitute for stock, they use calls to potentially generate income on shares they already hold. This strategy is called a covered call and involves selling the option rather than buying it. 

When a trader sells a covered call, instead of paying a premium, they receive the premium. However, the call can be exercised at the will of its owner (buyer) at any time up until expiration. If the call is ITM—below the stock's current price—on or before expiration, the likelihood that the option buyer will exercise their right to buy the underlying at the strike price increases. If this happens, the covered call seller is required to deliver the stock—100 shares for each options contract sold. 

Let's look at an example. Suppose a trader owns 100 shares of a stock that's trading at $79.34. They're long-term bullish on the stock but don't think the stock will move much in the next several weeks. The trader opens a covered call by selling an out-of-the-money (OTM) 82.5-strike call and collecting $2.37, or $237, in premium. 

If the stock stays below $82.50 between the time the trader sells the call and expiration, the option will likely expire worthless. If the call buyer does not exercise the option, the trader would keep the stock as well as the premium. Some traders refer to this as an "income enhancement" to the stock the trader owned. 

On the other hand, if the stock rallies above $82.50, the trader might be required to deliver the stock at $82.50 per share. Because the stock was at $79.34 when the trader sold the call, if the stock rallies above $82.50 by expiration, the trade's total return is capped at $553—$237 options premium plus a stock gain of $316—minus transaction costs. 

Buying a put option is usually considered a bearish strategy because the price of a put tends to rise as a stock price falls. If a trader is bearish on a stock, they might consider buying a put instead of shorting the stock. Shorting stock is very risky because there's no cap on potential losses, while the maximum loss for a put option is the premium paid. 

The protective put is a basic options strategy that can potentially help limit losses on a stock a trader already owns. The theory behind the strategy is that a trader buys the put option on a stock in their portfolio as a hedge in case the stock drops. 

Suppose a trader owns the stock in the example above, currently trading at $79.34. The trader still has a long-term bullish outlook but isn't comfortable with the shares dropping below $77.50 in the near term. Paying $2.76 ($276 per contract) for the OTM 77.5-strike put means the trader caps their losses at $4.60 if the stock falls below $77.50 on or before the options contract's expiration date. This is the difference between the current stock price and the strike price of the option ($79.34 – $77.50 = $1.84) plus the premium for the put ($2.76) in addition to transaction costs. 

In this example, the trader has limited their downside risk to $77.50, but it's still possible to profit if the stock continues to rise. And if it does move higher, against the trader's suspicions, they've spent $276 for the downside protection, which is deducted from any additional profit in the stock position itself. 

Although call and put options are used to speculate on directional plays on a stock, it's also possible to use them to potentially generate income and protect against losses in stock that's already in a trader's portfolio. Relatively basic strategies can help traders speculate, generate income, or hedge their risks, and they can be part of a well-diversified portfolio.