Last week we introduced you guys to derivatives. If you have not read it yet, please click on this link (We’re Shaking The Stigma on Derivatives) and read through before continuing on this article. We introduced the concept of a long call option and that it can be quite a useful tool when you possess limited capital but still want to invest in the stock market – a great thing called leverage. Today, we are going to cover the rest of the basics, introducing you all to short call options, as well as long and short put options. Firstly, allow us to provide some definitions:
Call Options are the right but not the obligation to BUY a stock at a specified price at a specified date.
Put Options are the right but not the obligation to SELL a stock at a specified price at a specified date.
Long: Another term for buying a stock that is not actually owned by the seller
Short: Another term for selling a stock that is not actually owned by the seller
Strike Price: the pice at which a put or call option can be exercised at.
In-The-Money: If the payoff (profit) from exercising an option immediately is positive. E.g if a call option with a strike price below current stock price is labeled as ‘in-the-money’.
Out-Of-The-Money: If the payoff from exercising is negative. E.g Call options with a strike price above the current stock price is labeled as ‘out-of-the-money’. The same goes for put options with a strike price below the current stock price.
Short Call Option
When you short a call option, you are basically ‘selling’ the right to ‘buy’. Simply, you are selling a call option (refer back to our definition here). Scenario: you are looking at Stock A and you think the price is going to fall. As an investor, you can actually short (sell) the underlying asset (the stock) as well as the call option. Until expiration, the premium you have paid is your profit. In other words, it caps your profits but carries an unlimited downside risk. The call option writer is paid a premium for taking on the risk with the obligation. This strategy is a bearish one (meaning you think the price is going to fall) and when the price falls below the strike price of the call option, the call option then expires worthless and your income is the premium you paid for the sale of that stock.
Take a look at the visual. You own 100 shares of Stock A and it is currently trading at $35 per share and you don’t believe the share price is going to increase. You then decide you’re going to sell a call option with a 1 month expiry at a strike price of $40, for $2. One contract = 100 shares, therefore, that’s a $200 premium. In other words, you are giving another investor the right to purchase Stock A from you for $40 a share anytime within the next 1 month.
If they buy this option, you get to keep the $200. At expiration, if Stock A’s price falls below $40, the call option expires worthless. If for example it goes up to $45, because you had to sell your shares at $40 you’ve pretty much missed out on a $5 gain per share. But you still earn a profit by selling share worth $35 on the market at $40 per share and you keep the $200 premium.
Long Put Option
If you’re entering into this strategy, then you believe the underlying stock price will fall. As an investor, you can sell the put option before expiration for either a profit or a loss, or hold it until its expiration date. Be mindful though, if you do not exercise before expiration then you will have to purchase the stock at the market price, and then sell your stock at the exercise price. In this scenario, your potential for making a profit is limited, meaning the maximum amount of profit you can make is equal to the strike price less the premium you paid for your put option originally. In other words, the risk you take on this strategy is limited to the price you paid for the option regardless of how high the stock price trades at expiration.
Stock XYZ is going for $40 right now. A put option with a strike price of $40 expires in 2 months is going for $2. As an investor, you’re predicting the stock XYZ’s price is going to decrease and therefore, you buy a contract for 100 shares at $2 = $200 (simply 100 shares multiplied by the cost of $2). Let’s say the stock falls to $35. You can sell the option now for $500 ($5 decrease from $40 and there are 100 shares). Because you paid $200 for the premium, in turn your total profit is $300. BUT, if the price goes up, your option expires worthless and you lose the initial $200 you paid...bummer, however there are ways to combat this… later on we will talk hedging your risk.
Short Put Option
This strategy involves the selling of a put option. You as an investor may predict that the price of a stock will rise with very little likelihood of it decreasing. Think of it as selling insurance on a stock. You know when you buy a house and you have to pay insurance so you’re covered for a crazy cyclone? Well in this case, you are the party who is receiving that premium a.k.a the insurance provider. The risk here however, is that if the price decreases dramatically, you still have to pay the strike price at expiration if you do not exercise your option. Meaning, you must actually buy the stock at the strike price (as no investor would buy from you if they can get the stock at a cheaper price), so you are purchasing a stock that is worthless to you. However, If the price rises and the stock price is above the strike price, it all starts to work in your favour with the premium you paid for that option becoming your profit.
A price of a stock is currently $20 per share. You think the stock is going to rise to $30 over the next few weeks. But, you don’t actually have enough money to purchase the stock at this price. Instead, you sell a put option with a strike price of $25 with a 1 month expiration date for $5. You profit is limited to the premium you pay ($500). The maximum you can lose will be the strike price minus the option price multiplied by the contract. So that will be ($25-$5)*100 = $2000.