Long Put Option Strategies:
Put options are a form of insurance for stocks. If your stocks decrease in value during a specific time-period, a put option gives you the right to sell your stock at an agreed upon price. Investors who wish to protect their portfolio’s value will therefore purchase puts in case prices fall. The action of purchasing a put option while holding long the underlying security is called a protective put option strategy. Investors can also buy put options without holding on to the underlying securities, also known as a long put option strategy. This allows for greater flexibility and leverage in a bear market. Conversely the risks of a long put option strategy is that it may lose value in a relatively short amount of time as well as incur permanent loss.
The basic features of a put option are as follows. The purchase price of an option is called the premium and each option contract covers a hundred shares. So an option contract that trades for a premium of $1 is worth $100 as it covers 100 shares. The strike price is the pre-determined price at which the option contract becomes exercisable if the underlying stock price falls below it. Options also carry an expiration date which specify the last day the option contract exists.
Let’s see an example about a protective put option strategy. Suppose you hold 100 shares of EIO, a publicly traded company that sells livestock to farmers.* You bought EIO at $40 this year and currently it’s trading at $50. In the short term you anticipate that with the recent growing trend in vegetarianism that revenues of EIO will fall short of expectations as farmers buy less livestock. You’re concerned that the stock price could react badly and might fall below your original purchase price. So in order to protect your investment you purchase 1 put option with a strike price of $50 for $3 in premium which expires at the end of the year in December. Shortly after purchasing the put, a consumer report comes out stating consumers are eating more salads than before causing the stock to sell off to $40. For the time until the option expires the stock continues to trade lower. By the December expiration date the stock is trading at $30. At this point you decide to exercise the put option to sell your shares at $50. By establishing the protective put option strategy which cost you $300 you effectively assured yourself a profit of $700 while avoiding a loss of $1,000. If the stock had continued to trade higher than $50 through until December the $300 put you purchased would lose it’s entire value.
The same scenario can also be recreated by just purchasing the put alone. The investor sensing the market may turn bearish, buys long puts at $3 for the $50 strike and December expiration for EIO. The price of EIO trades to $30 and the investor sells his put days prior to expiration, which is now worth $18, netting a $1,500 return. Conversely, the share price of EIO can also trade higher until expiration, causing the investor to lose the entire amount of $300 paid for his long put option investment strategy.
Long Call Option Strategy:
Purchasing a long call option works the same way as buying a put except that instead of insuring a stock from the downside risk you’re paying for the right to buy a stock at a specified price within a specific time period if the underlying trades above the strike price. The call option gives you flexibility to own stock later if it appreciates while not requiring you to invest in it during the interim if it does not. For this you pay a premium for a call option which covers 100 shares of stock. While there’s upside potential in purchasing a long call option, you can lose the entire amount invested in the long call option strategy.
Let’s See an Example: Suppose a friend of yours tells you about an up and coming software technology company that trades under the ticker IOIO.* He says that with the recent release of their new proprietary coding software the stock should double within the next 3 months. You understand that technology companies are risky investments but that by buying a call you could participate in the upside without having to buy the stock from the onset. IOIO currently trades at $10. The call option with a strike of $10 is trading at $2. In order to break even on your long call option strategy, the stock needs to trade up to $12. You purchase 1 call option with a strike price of $10 and expiration of 3 months at $2, paying $200 in total. For the next three months the stock churns higher all the way up to $18. Just before the option’s expiration date you decide to exercise the right to buy the stock at $10. You pay $1,000 for the stock which is now worth $1,800. In total you have an unrealized gain of $600 on the stock which you were able to lock in by only paying $200 for the option to do so. Conversely, if the stock never exceeds $10 by the expiration date you stand to lose the initial $200 invested. Additionally, if you purchased the 100 shares at $10 from the onset for $1,000, you could stand to lose your entire investment of $1,000 if the stock price goes to zero.
Calls can also be purchased and sold without the intent of exercising the right to buy the underlying stock. This strategy allows for capital gains to be made without ever having to purchase and sell the underlying stock. This strategy is risky as the price of the option can depreciate in a relatively short amount of time resulting in losses. Additionally, option investors can lose their entire investment in a call option.
Let’s see an Example: Using the prior scenario, suppose that instead of exercising the option to pay for the shares at $10 you instead decide to just sell the option just prior to expiration. The call option currently goes for $18.12 the day of expiration while the underlying stock trades for $18. Selling the call option brings in $1,812 from the sale, netting you a profit of $1,612. Conversely, the stock could also trade below $10 for the remainder of the time until expiration causing a permanent loss of the $200 you invested in the long call option strategy.
Selling a Covered Call Option Strategy:
Stock options can not only be bought by investors but sold by investors as well. This allows them to generate income by collecting on the premiums paid. Investors who wish to generate additional income in the form of premiums can utilize a covered call option strategy. A covered call strategy is when an investor sells a call option while at the same time holding the underlying stock long. This option trading strategy limits the upside potential of the investment during the duration of the option. It also eliminates the risk of potential infinite losses if the underlying stock price begins trading higher than the option strike price. However, an option seller is obligated to deliver the stock if the underlying stock price exceeds the strike price as well. Therefore, an investor who sells a covered call may have their shares sold at the strike price and may no longer participate in any future stock price increases. The risk of losing the entire investment in the stock less the premium collected is also the maximum potential loss.
Let’s See an Example: You currently hold 100 shares of stock in a livestock company called EIO.* The current price has been steady at $60 and heading into the next quarter you expect the company’s stock to not appreciate due to a seasonality effect. To increase your investment returns you decide to sell a call option with a $65 strike, 3 month expiration, for $2. You collect $200 in premium. The stock remains below $65 for the entire duration of the option contract, while the option contract expires worthless. You keep the entire $200 in premiums from selling the call option while also retaining shares in EIO.
In the same scenario as above, suppose that the stock price soars to $80 a few weeks after selling the call option. At any point you’re liable for your option to be assigned against you. Assignment can occur to a call option seller at any point the underlying security trades above the strike price. Let’s say that at expiration the stock hits $90. At that point you must fulfill your obligation to deliver 100 shares to the buyer of the call option. Your broker will place a sell of 100 shares of EIO at $65 in your account. Using your 100 shares of EIO stock you hold long you met the obligation to deliver the shares. Your net gain is the difference between your stock’s cost basis and the strike price plus the premium collected.
Lastly, using the same scenario as above, suppose that after selling the call of EIO for $2 the government issues a report which bans the sale of livestock indefinitely. The stock price of EIO drops to zero and never recovers until the option expires worthless. In this situation you experience the maximum possible loss and all that remains of your investment is the option premium of $200.
Selling a Cash Secured Put Option Strategy:
Investors who anticipate a stock to not trade below a certain price for a set time period can generate income by selling a put option. One such option trading strategy is selling a cash covered put option. This entails selling a put at a certain strike price while also posting cash as collateral in case the put option is exercised and shares are obligated to be purchased. The risks to this option strategy is that you may be forced to buy shares at a higher price then what the stock is currently worth. In addition, this means that the value of stock you’re obligated to purchase may also fall to zero as well.
Let’s See an Example: Shares of EIO are currently trading at $40.* You anticipate that the stock will remain higher for the foreseeable future. Therefore, you sell a put with a strike price of $40 for $2 with a three-month expiration. You collect $200 for selling the put but are also required to post $4,000 of cash as collateral in case the put is assigned against you. After three months the stock stays above $40 and you keep your $200 in premium. Conversely, using the same scenario, if the share price falls anywhere below $40 to say $0, you’re obligated to purchase 100 shares at $40 using the $4,000 you have set aside as collateral. This means that the 100 shares you purchased for $40 will be worth zero dollars and all you keep is the $200 in premiums.
For more information about the risks and complexities of option trading strategies please read the Characteristics and Risks of Options disclosure.
Since all option strategies come with tax considerations investors employing options trading should consult with a tax advisor to determine the tax consequences for each scenario of option trading strategies.
*The tickers are fictitious and are only intended to illustrate examples of complex option strategies.
All prices used in the examples are not representative of actual prices options can be worth at any time.