Getting started with options trading: Part 1

E*TRADE Securities

06/29/20

Calls and Puts

For many investors and traders, options can seem mysterious but also intriguing. If you want to start trading options, the first step is to clear up some of that mystery.

What are options, and why should I consider them?

An option you purchase is a contract that gives you certain rights. Depending on the option, you get the right to buy or the right to sell a stock, exchange-traded fund (ETF), or other type of investment for a specific price during a specific period of time.

Investors and traders use options for a few different reasons. For example:

  1. You can potentially make a profit—and not just when a stock rises, but also if it goes down.
  2. Options allow you to invest in the market while committing much less money than you would need to buy the stock outright.
  3. Options can help protect your portfolio. For example, if you own stocks, options can help protect those positions if things don't turn out as you planned.
  4. Certain options strategies can help you generate income.

The two basic types of options

There are two broad categories of options: "call options" and "put options". A call option gives the owner the right to buy a stock at a specific price. But the owner of the call is not obligated to buy the stock. That’s an important point to remember.

A put option gives the owner the right—but, again, not the obligation—to sell a stock at a specific price.

Understanding calls

Suppose you have a coupon from the Purple Pizza Company that lets you buy a pizza for $12, and it's valid for a year. This is essentially a call—it gives you an option to buy the pizza for $12, and it expires on a certain date. It's up to you whether you use it.

Normally, you'll only use the coupon if it has value. Let's say pizzas are on sale for $10. Are you going to use the $12 coupon? Obviously not.

On the other hand, if pizzas are selling for $20, then the coupon has $8 of real value, and you'll use it. In the language of options, you'll exercise your right to buy the pizza at the lower price.

Now, let's translate this idea to the stock market by imagining that Purple Pizza Company's stock is traded on the market. A Purple Pizza Co December 50 call option would give you the right to buy 100 shares of the company's stock for $50 per share on or before the call's December expiration.

If the shares are trading at less than $50, it’s unlikely that you would exercise the call, for the same reason that you wouldn't use a $12 coupon to buy a $10 pizza. Instead, you could hang on to the call option in hopes that the stock moves above $50 before the call expires.

Let's say the price of the stock does, in fact, go up to $55 per share. Now, if you were to exercise your option, you could buy shares for $50, then re-sell them on the open market for $55 each. Or you could hold on to the shares and see if the price goes up even further. Either way, you will have used your option to buy Purple Pizza shares at a below-market price.

Another possibility is to sell the call option to someone else before it expires, giving them the right to buy Purple Pizza shares at the below-market price of $50 per share. Since you bought the option when it had less value—i.e., when Purple Pizza stock was selling for less than $50 per share—you can potentially sell your option for a higher price and make a profit (not counting fees and commissions). In this scenario, you would make money buying and selling only the option; you’d never own actual Purple Pizza shares.

This is a good place to re-emphasize one key difference between a coupon and a call option. Most coupons are free, but as we've mentioned, you have to buy an option. The price is known as the premium, and it's non-refundable. You don't get it back, even if you never use (i.e., exercise) the option. So, remember to factor the premium into your thinking about profits and losses on options.

Understanding puts

The second type of option—put options—are a form of protection. They give you the right to sell a stock at a specific price during a specific time period, helping to protect your position if there's a downturn in the market or in a specific stock.

It's a simple idea. Let's say you own 100 shares of Purple Pizza, and the stock is trading at $50 per share. If you're worried the price might drop more than 5%, you can buy a $47.50 put, which gives you the right to sell your shares for that price until the option expires. Even if the market price falls to $35 per share, you can sell for $47.50, potentially limiting your losses or protecting profits.

Now you've learned the basics of the two main types of options and how investors and traders might use them to pursue a potential profit or to help protect an existing position.

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What to read next...

In Part 1, we covered the basics of call and put options. When you buy these options, they give you the right to buy or sell a stock or other type of investment.

Watch the video to learn the four main reasons investors use options strategies in their portfolios: flexibility, leverage, hedging, and income generation.

There are certain options strategies that you might be able to use to help protect your stock positions against negative moves in the market. Read this article to learn more.

Looking to expand your financial knowledge?