Options are a leveraged asset class. Leverage means that you must only put down a small percentage of money to purchase the underlying asset. Some people think of this as rent vs. buy. Both a renter and a buyer can benefit by controlling the asset. For example, whether you rent or buy a place to live, you get the many benefits of living there.
An owner of a stock gets the benefits of owning that stock. An investor could opt to rent those benefits from the owner for a period of time- just like a home renter gets to live in the home owned by someone else for a period of time. How does one rent the ownership benefits of a stock? By buying an option on that stock. In exchange for the equivalent of “rent”- which is what they pay for the option they buy- the option buyer gets to enjoy the upside potential of the stock while the option exists… or until they sell their option to someone else.
Most people who trade options will trade stock options. Why? Probably because the overall experience is so similar and there is no margin requirement when one only buys options. While there are 21 different option strategies that can be traded, most choose the simplest of them: buying what are called call & put options. When one buys a:
call option, they are bullish on the short-term potentials of the underlying stock… that is they think the stock to which the option is tied is going to rise in value very soon.
put option, they are bearish on the short-term potential of the underlying stock… that is, they think the stock is about to meaningfully fall in value very soon.
This simple image is worth staring at until you remember it…
Stock Investors can buy a stock if they are bullish and short-sell it if they are bearish. Option buyers set up most of the same profit opportunity for a fraction of the cost by buying call & put options. In other words, while BOTH types of traders can make money in near-term bull or bear scenarios (yes you can make great money even when stocks or overall markets are falling too), the option trader- like the home renter- can use much less money to enjoy most of the same benefit.
Not too long ago before cell phones, we had landline phones that hung on a wall or sat on a table:
When that phone rang, we picked UP the receiver to take the call.
When we finished speaking on the phone, we put the receiver back DOWN.
Another way to think of options is this way: Call UP and Put DOWN.
If you buy a Call option, you gain the right- but not the obligation- to buy 100 shares of stock at a specific price- called the strike price- within a certain amount of time. It is a bullish bet on that stock.
For example, if XYZ Inc. stock is at $50/share right now and you think it is going to $70 soon, you could buy a Call Option to have that right to buy XYZ stock at $50/share for a specific period of time, regardless of where it goes from here. If it does- in fact- rise to $70 while you hold the option, you can exercise the option to buy that stock at $50/share and then- if you like- immediately sell it for $70 to profit $20 per share (minus whatever you paid for the option, which is called the option premium).
If XYZ Inc. roared to $100 or $200 or $500-per-share while you held the option, you could still exercise the option to buy the stock at $50/share and then hold the stock for more gains or sell it at $100 or $200 or $500-per-share.
Better yet, just like the stock market, the option market is liquid, so unless you are the very last investor to own the option just before the time it is in play runs out (called the expiration date), you do not even have to exercise it to harvest your profit. Instead, you can just sell it to someone else who sees even greater potential in it ahead of option expiration… exactly like you sell a stock to someone else.
We will take a little deeper look at this shortly but let us first cover the OTHER type of option…
If you buy a Put option, you gain the right- but not an obligation- to sell 100 shares of stock at a specific price- called the strike price- within a certain amount of time. It is a bearish bet on that stock.
For example, instead of feeling bullish on XYZ, let us imagine you are very bearish on it. It is at $50 now but you think it is about to plunge down to around $30 per share. You could buy a put option with a strike price of $50 to lock in the right to sell the person who originally sold the option (called the option writer) on XYZ at $50 per share regardless of how low it may fall.
Let us imagine it does indeed fall to $30 just as you expect. If so, you could buy the stock at the market price of $30/share and exercise your put option to then sell it to (sometimes reworded as ‘put it to’) the option writer for $50 per share. Note the definition reference to you “having the right- but not the obligation…” to exercise this option you have purchased. That means you can use it or let it eventually cease to exist when the time associated with it ends (called expiration).
On the other hand, the person who originally WROTE or sold the option has an obligation to do whatever the option commits them to do. In this example, the option writer is obligated to buy the stock at $50 per share regardless of how low it goes while the option exists. If XYZ fell all the way to 1¢/share, you- as put option buyer- could buy shares for 1¢ each and the writer would have to buy them from you for $50 per share. There are no choices for option writer- they DO own a very solid obligation to fulfill their end of the arrangement.
And just like with call options, exercising a put is not the only way out of it. If there is sufficient time until the option expires, you can simply sell the put option to someone else- just like selling stock to someone else- to harvest whatever profit has been made while you have held the option… or bail out with a limited loss if your guess on stock price direction is wrong. This sell (to close) the option position is as easy as it is with stocks: hit the button to exit the position and you’re out.
So, let us summarize a few unique terms associated with options vs. stocks:
Call option acts much like buying a stock. You are bullish on the (underlying) stock.
Put option is like shorting a stock. You are bearish on the short-term future of the stock.
Strike Price is the price at which the option writer is obligated to sell (in a call option) or buy (in a put option) if the option is exercised. It makes no difference where the stock price is on exercise day. They are obligated to that strike price.
Expiration Date is the date when an option will expire or cease to exist. Unlike a stock which you could conceptually hold up to forever before cashing out, an option has a finite amount of time to pay off… like a home renter can only enjoy the benefits of living in a home owned by someone else until the lease period expires. This is probably the SECOND most standout difference of options vs. stocks to a stock investor: the option buyer must also forecast a timetable in which what they expect to happen will- in fact- occur. They choose an option with at least enough time for this expectation to actually play out. Do they need a month or 2 months or 3 months or 6 months for the big move to occur? If so, a wide variety of expiration dates associated with options provide the right choice to accommodate the desired window of time.
Option Buyer buys the option. They have a right- but no obligation- to ultimately exercise it or just liquidate it to some other buyer in the market. Over the life of the option, it may have MANY owners as each person opts to exit the trade when they achieve their target profit or to cut a loss. Only the very last owner might exercise the option (and only if it is profitable to do so).
Option Writer sells the option. They take on an obligation to sell or buy the underlying stock if the option is ultimately exercised. There is only one writer for an option. They own the obligation to fulfill the option for the entire time the option exists. If the last option owner exercises the option, the original link in the chain- this option writer- is the one who is exercised.
Option Contract (not covered above): 100 options packaged as a bundle. Though they are priced as singles, options cannot be purchased that way. Instead, a trader must buy 100 options at a time… which basically means they are buying a right but not an obligation to benefit from a block of 100 shares of the underlying stock. Why can’t a trader buy just 1 option instead of a hundred at a time? We will cover this in the next section of this lesson…
We just referenced the Expiration Date as the “second” most standout difference of options for stock traders. What is the BIGGEST difference you would notice?
Again, leaning on this concept of hypothetical XYZ Inc. being $50/share as a potential stock investment, what might an option be to lock up much of the same potential cost? There are MANY answers to this question but all of them are generally “A FRACTION OF THE STOCK PRICE.” XYZ at $50 might have a call option available to capitalize on the very same expectation for as little as 50¢… or a dollar or two. An option with more time to be right (an expiration date further out into the future) and/or a more favorable strike price might cost upwards of $5 or $10 each. But the more important concept here is that:
an option buyer (like the home renter) can lock up much of the same potential in temporarily controlling the underlying asset during the term the option (or lease) exists… for a fraction of the cost of actually owning the underlying asset itself.
Or more simply: you do not have to put much money into an option trade to have much of the same upside potential as buying the underlying stock itself. Because individual options are so cheap, commissions on 50¢ or $2 would be towards zero money for your broker… and that is why they are bundled into contracts of 100 options. Wall Street is not interested in making a fraction of a cent or two in commission, so a contract ups that to enough commission to make the transactions interesting to them.
So, this contract concept means that to buy a:
50¢ option, you would have to get 100 of them in 1 contract for $50.
$2 option, you would have to get 100 of them for $200.
$7.50 option, you would have to get 100 of them for $750.
If XYZ Inc. stock costs $50/share and you decide to buy 100 shares, it will cost you $5,000 for those shares. If the XYZ Inc. call option you like is $2.00, you multiply it by one hundred to know the contract price: $200. In this scenario, much of the very same trading upside is locked up for either $5,000 or $200. And therein lies perhaps the greatest attraction to options… and why they are called a leveraged trading vehicle.
If XYZ Inc. stock runs up to $60.00/share, the stock trader will profit $10/share ($60 now vs. $50 when purchased = $10 of profit). $10 times the 100 shares owned = $1,000 of profit or a 20% gain on the $50/share investment.
Assuming the option buyer chose a specific option that best mirrored the stock trade, the $2 option is now worth $10 (current stock price of $60 minus a chosen option strike price at 50 = $10). To buy that option, you had to buy 100 options on 100 shares of stock in an option contract. So that’s $10 times $100, or the same $1,000. How much did the option contract cost? $200. So, $200 in and $1000 out is a 5X gross gain. Instead of a 20% gain in the stock trade, the option trade grosses 500%.
Now the option trader had to pay that premium for this right and that has to come out of that kind of tabulation, but we are opting to keep the math quite simple. The stock trader would actually have the greater profit in dollars because they did not have to pay an option’s premium. However, it costs them a lot more dollars to buy the stock instead of the option… and thus the net percentage gains for each will still dramatically favor the option buyer.
Q: What about the wrong-way scenarios? What if XYZ plunges?
If the investment turns out to be dud- and we have all had our share of them at some point in our investing lives- and takes a big dive, consider the worst-case scenarios:
stock owner could lose all $5,000 they invested in the stock if it went to $0 (bankruptcy)
option trader could lose all $200 they invested in the options contract.
Both kinds of traders would lose all the money they had in the trade. There is just much less in the options version of that trade.
Now that’s the worst case, which- while bankruptcies do happen and sometimes happen as a surprise- the reality is that most stocks rise & fall and some can do so dramatically at times. While options look especially good in the worst-case scenario due to the relatively tiny loss, in non-worst-case scenarios where XYZ Inc. stock takes a big dive, the lack of an expiration date on stock means that the stock owner could basically sit on that loss until it comes back to profitability again. It might take years or decades, but a stock owner could simply wait to “win” on any stock trade by simply holding it long enough.
An option trader has no such patience card to play. From the time that one buys an option to when they exit, exercise it, or let it expire worthless, a clock is ticking. A day is approaching- expiration day- when the option will simply cease to exist. So, within the tremendous “rent” (that stock upside) bargain of option pricing and relatively tiny loss potential in worst-case scenarios, the great limitation of options trading is that ticking clock: there is only so much time available for the option traders’ belief- bull or bear- to play out. If it moves the wrong way and stays there until expiration, the option trader may bail out with a sizable loss of the $200 in the XYZ example or hold it to expiration and take a total loss of the $200.
TIME IS NOT ON THE OPTION TRADERS SIDE
That last paragraph leads us to another key option concept: time decay. Very simply, because there is this ticking clock until expiration day, options are called a waning asset. What that means is that even if the stock is stable at some price for a period of time, a call option on that stock over that same time is likely to lose a little value each day anyway.
For example, imagine that you have purchased that XYZ Inc Call option with the stock at $50. Since you purchased a call, you are expecting XYZ Inc. to roar higher ASAP. What if it just hangs right there at about $50 for the next few weeks? For the:
stock trader, this is no big deal. If it is still at $50 even 6 weeks from now, they’ve neither made any money nor lost any. It is still at “break even.”
option trader, this same scenario is going to result in an erosion of the value of the option. They have basically lost 6 weeks for the stock to move bullishly, and time decay has decayed away some of the value of their option. If it was $2 when they purchased it, it might be down a fair percentage depending on the remaining time until expiration and the strike price.
The concept of time decay is often shown as a graph that typically looks something like this…
As implied by the shape, when the option trader has lots of time, the time decay slope- the upper blue line- is modest, resulting in only a little erosion of price if the stock price is doing nothing. As expiration day approaches- especially beyond those last 3 months- the slope of the curve is steeper, meaning there is much more time decay eroding the price of the position.
Why? What is really happening here? When you make a trade, you are making a bet. The option trader is betting on something meaningful happening right away. There is only so much time for this bet to pay off. As that window of time for a payoff shrinks, the odds of this bet winning are also shrinking. As odds stretch out, those willing to buy into a given bet thin out. Fewer betters/buyers (of a long shot) means lower prices.
Time decay is often considered an enemy in options trading. Think of it like tooth decay. When the cavity begins, you barely even notice it and the actual damage is minor. But let enough time pass and you will eventually feel the pain. Let too much time pass and you may lose the entire tooth.
However, through another lens, this is simply another variable affecting the price of an investment. There are plenty of options traders who will be actively buying options right into expiration week and even on expiration morning. Why? Because an option with almost no time left is likely to be a dirt-cheap option. Instead of paying 50¢ or $2 as we have shown in several examples, it might be down to a few cents per option. You might be able to buy an entire contract for $2! If a big move can happen in the almost-no-time that remains, a tiny investment can pay off big, or a sizable but high-risk investment in dirt cheap options that close to expiration can yield a huge ROI in just hours or minutes.
Most people who learn about time decay will conclude the very same thing: “If I trade options, I’ll only buy those with abundant time until expiration.” and you can do that. BUT by making your “bet” easier to win (by having more time for it to pan out), can you guess the consequence? You will pay much more for the option. As you make choices to strengthen your odds of winning, the “bet” will cost more. As you lengthen the odds for it to work out, the option will cost less.
With a focus on time decay, the:
best solution is buying right before the big move begins: the gains outrun the decay.
undesirable scenario for time decay is buying in the steeper part of the slope (to get a cheaper price on the option) and then the stock doing nothing. The value will erode fast with a stationary stock.
worst scenario is the stock immediately and sizably moves in the wrong direction, wiping out almost all of the value of the option without much time left for any recovery. Most options in this scenario will expire worthless on expiration day.
FOR THE BEARS: SHORTING Vs. PUT BUYING
When one is bearish on a stock, they might short that stock. Shorting stock is selling shares you do not actually own with an eye towards buying them later at a lower price to pay back the “loan.” For example, XYZ is $50. You think it is going to fall to $30. You short-sell XYZ at $50 today. If it does fall to $30, you “cover” your short position by buying it at $30 and enjoy your $20 profit-per-share on a bearish play.
The option trader will buy a put option to lock up much of the same profit potential. The same $20 profit on the underlying stock falling to $30/share is up for grabs (minus what they pay for the option itself). So, there is almost as much profit in the option for being right.
Q: But what if you are wrong about the bearish fall?
XYZ has a big announcement and the stock rockets towards infinity. If you have not included some kind of mechanism to bail out like a stop loss order, there is unlimited loss potential in that short sale. To pay back the loan of XYZ stock you sold for $50/share, you have to now pay $X/share for it… and $X is running towards infinity. This can be a catastrophic loss for a short seller with no stop.
The option traders put option has a hard-capped loss maximum at the money paid for the option. If that contract costs $200, $200 is the maximum that can be lost as XYZ runs towards infinity. Because of this, even those who much prefer stocks vs. options will consider the put option over the shorting play in this scenario. And one big reason those wanting to short sell need a margin account but put options buyers do NOT need one is that the latter has a hard-capped loss while the former has theoretically unlimited risk.
THE HEDGE PLAY
One more way to use put options is as a hedge. A hedge in this context minimizes the downside risk of loss by placing another kind of trade that will act as protection. This is often presented like buying insurance on a valuable asset like your home when you fear the risk of loss.
Suppose you hold 10,000 shares of XYZ, currently at $50/share. You have $500,000 at risk. Suppose XYZ’s new wonder drug clinical trial results are going to be released in the next couple of weeks, which will be a catalyst for either a huge gain or a huge fall. You believe it is likely to come out well, but you worry that it may not and thus hit the current stock valuation in a big way. How could you protect your position against downside risk without going to cash and perhaps missing the big upside on the anticipated good news?
One quite easy way would be to buy enough put options to hedge the downside risk. 10,000 XYZ shares divided by 100 (options in a contract) means that if you purchased 100 put option contracts, you would have a short-term downsize hedge on all 10,000 shares of XYZ. Those put options would deliver a gain in a potential big plunge if the news is bad. This sets up a 2-sided trade. If XYZ has:
great news about the trial, the stock price will soar, but the put options value will plunge.
bad news about the trial, the stock price will plunge, but the put options value will soar.
So, you have basically configured a win-and-lose side in either scenario with this combination of stock and put options. Like buying insurance on your home, you are spending a chunk of money hoping that it buys you nothing in return (which in a very pure sense is a trading LOSS on that investment)… that is, your home will not be destroyed so you will NOT have to make a claim. However, if the home is destroyed, the “investment” in that downside risk scenario will pay off and thus prevent a catastrophic loss. The home insurance buyer hopes for a 0% return on the insurance “investment”… but if the home IS destroyed, that probable loss becomes a very beneficial “trade.”
In this XYZ example, the put options are functioning like insurance just in case the trial is sour and your $500K of stock takes a big valuation hit. If so, you would then harvest your profit on the put options and potentially hang on to XYZ stock for it to eventually come back from this fall.
On the other hand, if it is good news on XYZ, the put options will probably be left to expire worthless… just like the ROI on the home insurance “expires worthless” each year that you do not make any claim.
The magic in this hedge is in selecting the right put options to minimize your cost of the “insurance” while protecting you against much of your potential loss. This is like shopping around for a home insurance policy that will give you the coverage you seek for the lowest price. In this case, you would be shopping around for the right combination of strike price and expiration date at a desirable price.
The difference between complete protection and most of the potential loss on bad XYZ news might be thought of as the insurance deductible… which is a number you basically choose to cover out of pocket before your home insurance policy kicks in. The “deductible” in this XYZ hedge might be set by a choice of strike price being far enough out that you will suffer SOME loss if you have to harvest profit from the options. Why would you choose that? The “insurance” would cost less… just like choosing a higher deductible vs. a lower (or no deductible) on your home insurance. You take on additional out-of-pocket loss in an insurance claim in exchange for a cheaper insurance price.
Since you know the news is going to hit in a predictable period of time, you do not need much time in the put options, which means you could shop for those closer to expiration and thus consider relatively cheap put options. This would be like being worried about something happening to your home in only one season and opting to buy insurance for only that season. Obviously, short-term coverage will cost less than long-term coverage… so a short-term hedge will cost less than a long-term one. Thus, you can buy the downside protection for relatively cheap while still very much having that protection if needed.
SUMMARY OF CORE CONCEPTS
There is a great abundance of other ways to use options in investing, but this lengthy lesson covered a selection of our own favorites. Since it is a long lesson, let us summarize key concepts…
Just like a stock trader, the option trader will:
identify a stock likely to move up or down.
be confident a meaningful move is impending.
Unlike the stock trader, the option trader takes on 2 additional tasks:
picking the right strike price to maximize their trade potential. MANY strike prices are available. More favorable strike prices will make an option cost more. Longer shot strikes make it cost less. There is an entire art & science (plus some hope & luck) to selecting the right strike price for any given options trade.
pre-determining the window of time that the anticipated big move will occur and buying as close as they can to when the big move will begin. Buying more time makes the option cost more. Buying too little time risks a bigger loss and/or missing the big move. Thus, there is also an art & science (plus hope & luck) to selecting a Goldilocks expiration date too.
A stock trader can “be early” or “be late” with minimal consequence because their ultimate card to play is simply waiting out anything that happens. If they wait long enough, just about any trade can end up closing as a winner. Thus, if a stock trader has sufficient patience and money to tie up for up to exceptionally long periods of time, they can enjoy a high win ratio by simply waiting for losing positions to become wins again… even if that might take a decade or longer.
An option trader is ideally buying immediately before the big move occurs and exiting as the big move nears its peak, all within the window of time they chose ahead of the option’s expiration date. An option owner needs big results to occur within a short window of time they control. Even a “stock does nothing” scenario is generally bad for the option holder due to time decay eroding the value of the option. Thus, most option purchases end up as losses because there is almost no flexibility if the trader is wrong about the timing of the move. They simply take their loss and move on to another trade.
In turn, the:
stock trader- like a homeowner- will pay much more to fully own & control the stock.
option trader- like a home renter- will pay a relatively small fraction to temporarily gain most of the upside potential of the position.
In a worst-case (company bankruptcy) scenario, both the stock and option trader could lose up to 100% of the money they have in each position. This can be sizable for the stock trader but only a fraction of that for the option trader.
In a shorting vs. put buying comparison, both can take profitable advantage of a falling stock price. The put option buyer can harvest almost as much profit as the short seller. However, the risk profile is hard-capped downside risk in the put option vs. theoretical unlimited risk for the stock short seller.
The hedging approach to using put options like buying insurance. This is a trade you do not really want to “win” as it is only a backup to what you think will happen with a big stock position. If you need it, it is there to minimize the pain of the stock taking a dive. If you do not need it, the stock likely rose as hoped and you let the “insurance” expire much like letting an actual insurance policy expire.
There is much more that can learned about options but hopefully, the substantial overview you just read establishes solid foundational knowledge. If you would like to learn even more, consider trying our flagship alert service, in which we share some simple call & put option recommendations each month with detailed, trade-by-trade, educational rationale explaining why we like each trade. One of the best ways to learn anything in trading is by actually trading. Our combination of novice-friendly recommendations with educational rationale is a terrific way to “learn as you earn.” You can lean on Sal’s nearly 40 years of experience helping you succeed while learning from him and our team all throughout the year(s). Check out Sal’s Private Trades.
Options are a leveraged asset class. Leverage means that you must only put down a small percentage of money to purchase the underlying asset. Some people think of this as rent vs. buy. Both a renter and a buyer can benefit by controlling the asset. For example, whether you rent or buy a place to live, you get the many benefits of living there.
An owner of a stock gets the benefits of owning that stock. An investor could opt to rent those benefits from the owner for a period of time- just like a home renter gets to live in the home owned by someone else for a period of time. How does one rent the ownership benefits of a stock? By buying an option on that stock. In exchange for the equivalent of “rent”- which is what they pay for the option they buy- the option buyer gets to enjoy the upside potential of the stock while the option exists… or until they sell their option to someone else.
Most people who trade options will trade stock options. Why? Probably because the overall experience is so similar and there is no margin requirement when one only buys options. While there are 21 different option strategies that can be traded, most choose the simplest of them: buying what are called call & put options. When one buys a:
This simple image is worth staring at until you remember it…
Stock Investors can buy a stock if they are bullish and short-sell it if they are bearish. Option buyers set up most of the same profit opportunity for a fraction of the cost by buying call & put options. In other words, while BOTH types of traders can make money in near-term bull or bear scenarios (yes you can make great money even when stocks or overall markets are falling too), the option trader- like the home renter- can use much less money to enjoy most of the same benefit.
Not too long ago before cell phones, we had landline phones that hung on a wall or sat on a table:
Another way to think of options is this way: Call UP and Put DOWN.
If you buy a Call option, you gain the right- but not the obligation- to buy 100 shares of stock at a specific price- called the strike price- within a certain amount of time. It is a bullish bet on that stock.
For example, if XYZ Inc. stock is at $50/share right now and you think it is going to $70 soon, you could buy a Call Option to have that right to buy XYZ stock at $50/share for a specific period of time, regardless of where it goes from here. If it does- in fact- rise to $70 while you hold the option, you can exercise the option to buy that stock at $50/share and then- if you like- immediately sell it for $70 to profit $20 per share (minus whatever you paid for the option, which is called the option premium).
If XYZ Inc. roared to $100 or $200 or $500-per-share while you held the option, you could still exercise the option to buy the stock at $50/share and then hold the stock for more gains or sell it at $100 or $200 or $500-per-share.
Better yet, just like the stock market, the option market is liquid, so unless you are the very last investor to own the option just before the time it is in play runs out (called the expiration date), you do not even have to exercise it to harvest your profit. Instead, you can just sell it to someone else who sees even greater potential in it ahead of option expiration… exactly like you sell a stock to someone else.
We will take a little deeper look at this shortly but let us first cover the OTHER type of option…
If you buy a Put option, you gain the right- but not an obligation- to sell 100 shares of stock at a specific price- called the strike price- within a certain amount of time. It is a bearish bet on that stock.
For example, instead of feeling bullish on XYZ, let us imagine you are very bearish on it. It is at $50 now but you think it is about to plunge down to around $30 per share. You could buy a put option with a strike price of $50 to lock in the right to sell the person who originally sold the option (called the option writer) on XYZ at $50 per share regardless of how low it may fall.
Let us imagine it does indeed fall to $30 just as you expect. If so, you could buy the stock at the market price of $30/share and exercise your put option to then sell it to (sometimes reworded as ‘put it to’) the option writer for $50 per share. Note the definition reference to you “having the right- but not the obligation…” to exercise this option you have purchased. That means you can use it or let it eventually cease to exist when the time associated with it ends (called expiration).
On the other hand, the person who originally WROTE or sold the option has an obligation to do whatever the option commits them to do. In this example, the option writer is obligated to buy the stock at $50 per share regardless of how low it goes while the option exists. If XYZ fell all the way to 1¢/share, you- as put option buyer- could buy shares for 1¢ each and the writer would have to buy them from you for $50 per share. There are no choices for option writer- they DO own a very solid obligation to fulfill their end of the arrangement.
And just like with call options, exercising a put is not the only way out of it. If there is sufficient time until the option expires, you can simply sell the put option to someone else- just like selling stock to someone else- to harvest whatever profit has been made while you have held the option… or bail out with a limited loss if your guess on stock price direction is wrong. This sell (to close) the option position is as easy as it is with stocks: hit the button to exit the position and you’re out.
So, let us summarize a few unique terms associated with options vs. stocks:
We just referenced the Expiration Date as the “second” most standout difference of options for stock traders. What is the BIGGEST difference you would notice?
Again, leaning on this concept of hypothetical XYZ Inc. being $50/share as a potential stock investment, what might an option be to lock up much of the same potential cost? There are MANY answers to this question but all of them are generally “A FRACTION OF THE STOCK PRICE.” XYZ at $50 might have a call option available to capitalize on the very same expectation for as little as 50¢… or a dollar or two. An option with more time to be right (an expiration date further out into the future) and/or a more favorable strike price might cost upwards of $5 or $10 each. But the more important concept here is that:
an option buyer (like the home renter) can lock up much of the same potential in temporarily controlling the underlying asset during the term the option (or lease) exists… for a fraction of the cost of actually owning the underlying asset itself.
Or more simply: you do not have to put much money into an option trade to have much of the same upside potential as buying the underlying stock itself. Because individual options are so cheap, commissions on 50¢ or $2 would be towards zero money for your broker… and that is why they are bundled into contracts of 100 options. Wall Street is not interested in making a fraction of a cent or two in commission, so a contract ups that to enough commission to make the transactions interesting to them.
So, this contract concept means that to buy a:
If XYZ Inc. stock costs $50/share and you decide to buy 100 shares, it will cost you $5,000 for those shares. If the XYZ Inc. call option you like is $2.00, you multiply it by one hundred to know the contract price: $200. In this scenario, much of the very same trading upside is locked up for either $5,000 or $200. And therein lies perhaps the greatest attraction to options… and why they are called a leveraged trading vehicle.
If XYZ Inc. stock runs up to $60.00/share, the stock trader will profit $10/share ($60 now vs. $50 when purchased = $10 of profit). $10 times the 100 shares owned = $1,000 of profit or a 20% gain on the $50/share investment.
Assuming the option buyer chose a specific option that best mirrored the stock trade, the $2 option is now worth $10 (current stock price of $60 minus a chosen option strike price at 50 = $10). To buy that option, you had to buy 100 options on 100 shares of stock in an option contract. So that’s $10 times $100, or the same $1,000. How much did the option contract cost? $200. So, $200 in and $1000 out is a 5X gross gain. Instead of a 20% gain in the stock trade, the option trade grosses 500%.
Now the option trader had to pay that premium for this right and that has to come out of that kind of tabulation, but we are opting to keep the math quite simple. The stock trader would actually have the greater profit in dollars because they did not have to pay an option’s premium. However, it costs them a lot more dollars to buy the stock instead of the option… and thus the net percentage gains for each will still dramatically favor the option buyer.
Q: What about the wrong-way scenarios? What if XYZ plunges?
If the investment turns out to be dud- and we have all had our share of them at some point in our investing lives- and takes a big dive, consider the worst-case scenarios:
Both kinds of traders would lose all the money they had in the trade. There is just much less in the options version of that trade.
Now that’s the worst case, which- while bankruptcies do happen and sometimes happen as a surprise- the reality is that most stocks rise & fall and some can do so dramatically at times. While options look especially good in the worst-case scenario due to the relatively tiny loss, in non-worst-case scenarios where XYZ Inc. stock takes a big dive, the lack of an expiration date on stock means that the stock owner could basically sit on that loss until it comes back to profitability again. It might take years or decades, but a stock owner could simply wait to “win” on any stock trade by simply holding it long enough.
An option trader has no such patience card to play. From the time that one buys an option to when they exit, exercise it, or let it expire worthless, a clock is ticking. A day is approaching- expiration day- when the option will simply cease to exist. So, within the tremendous “rent” (that stock upside) bargain of option pricing and relatively tiny loss potential in worst-case scenarios, the great limitation of options trading is that ticking clock: there is only so much time available for the option traders’ belief- bull or bear- to play out. If it moves the wrong way and stays there until expiration, the option trader may bail out with a sizable loss of the $200 in the XYZ example or hold it to expiration and take a total loss of the $200.
TIME IS NOT ON THE OPTION TRADERS SIDE
That last paragraph leads us to another key option concept: time decay. Very simply, because there is this ticking clock until expiration day, options are called a waning asset. What that means is that even if the stock is stable at some price for a period of time, a call option on that stock over that same time is likely to lose a little value each day anyway.
For example, imagine that you have purchased that XYZ Inc Call option with the stock at $50. Since you purchased a call, you are expecting XYZ Inc. to roar higher ASAP. What if it just hangs right there at about $50 for the next few weeks? For the:
The concept of time decay is often shown as a graph that typically looks something like this…
As implied by the shape, when the option trader has lots of time, the time decay slope- the upper blue line- is modest, resulting in only a little erosion of price if the stock price is doing nothing. As expiration day approaches- especially beyond those last 3 months- the slope of the curve is steeper, meaning there is much more time decay eroding the price of the position.
Why? What is really happening here? When you make a trade, you are making a bet. The option trader is betting on something meaningful happening right away. There is only so much time for this bet to pay off. As that window of time for a payoff shrinks, the odds of this bet winning are also shrinking. As odds stretch out, those willing to buy into a given bet thin out. Fewer betters/buyers (of a long shot) means lower prices.
Time decay is often considered an enemy in options trading. Think of it like tooth decay. When the cavity begins, you barely even notice it and the actual damage is minor. But let enough time pass and you will eventually feel the pain. Let too much time pass and you may lose the entire tooth.
However, through another lens, this is simply another variable affecting the price of an investment. There are plenty of options traders who will be actively buying options right into expiration week and even on expiration morning. Why? Because an option with almost no time left is likely to be a dirt-cheap option. Instead of paying 50¢ or $2 as we have shown in several examples, it might be down to a few cents per option. You might be able to buy an entire contract for $2! If a big move can happen in the almost-no-time that remains, a tiny investment can pay off big, or a sizable but high-risk investment in dirt cheap options that close to expiration can yield a huge ROI in just hours or minutes.
Most people who learn about time decay will conclude the very same thing: “If I trade options, I’ll only buy those with abundant time until expiration.” and you can do that. BUT by making your “bet” easier to win (by having more time for it to pan out), can you guess the consequence? You will pay much more for the option. As you make choices to strengthen your odds of winning, the “bet” will cost more. As you lengthen the odds for it to work out, the option will cost less.
With a focus on time decay, the:
FOR THE BEARS: SHORTING Vs. PUT BUYING
When one is bearish on a stock, they might short that stock. Shorting stock is selling shares you do not actually own with an eye towards buying them later at a lower price to pay back the “loan.” For example, XYZ is $50. You think it is going to fall to $30. You short-sell XYZ at $50 today. If it does fall to $30, you “cover” your short position by buying it at $30 and enjoy your $20 profit-per-share on a bearish play.
The option trader will buy a put option to lock up much of the same profit potential. The same $20 profit on the underlying stock falling to $30/share is up for grabs (minus what they pay for the option itself). So, there is almost as much profit in the option for being right.
Q: But what if you are wrong about the bearish fall?
XYZ has a big announcement and the stock rockets towards infinity. If you have not included some kind of mechanism to bail out like a stop loss order, there is unlimited loss potential in that short sale. To pay back the loan of XYZ stock you sold for $50/share, you have to now pay $X/share for it… and $X is running towards infinity. This can be a catastrophic loss for a short seller with no stop.
The option traders put option has a hard-capped loss maximum at the money paid for the option. If that contract costs $200, $200 is the maximum that can be lost as XYZ runs towards infinity. Because of this, even those who much prefer stocks vs. options will consider the put option over the shorting play in this scenario. And one big reason those wanting to short sell need a margin account but put options buyers do NOT need one is that the latter has a hard-capped loss while the former has theoretically unlimited risk.
THE HEDGE PLAY
One more way to use put options is as a hedge. A hedge in this context minimizes the downside risk of loss by placing another kind of trade that will act as protection. This is often presented like buying insurance on a valuable asset like your home when you fear the risk of loss.
Suppose you hold 10,000 shares of XYZ, currently at $50/share. You have $500,000 at risk. Suppose XYZ’s new wonder drug clinical trial results are going to be released in the next couple of weeks, which will be a catalyst for either a huge gain or a huge fall. You believe it is likely to come out well, but you worry that it may not and thus hit the current stock valuation in a big way. How could you protect your position against downside risk without going to cash and perhaps missing the big upside on the anticipated good news?
One quite easy way would be to buy enough put options to hedge the downside risk. 10,000 XYZ shares divided by 100 (options in a contract) means that if you purchased 100 put option contracts, you would have a short-term downsize hedge on all 10,000 shares of XYZ. Those put options would deliver a gain in a potential big plunge if the news is bad. This sets up a 2-sided trade. If XYZ has:
So, you have basically configured a win-and-lose side in either scenario with this combination of stock and put options. Like buying insurance on your home, you are spending a chunk of money hoping that it buys you nothing in return (which in a very pure sense is a trading LOSS on that investment)… that is, your home will not be destroyed so you will NOT have to make a claim. However, if the home is destroyed, the “investment” in that downside risk scenario will pay off and thus prevent a catastrophic loss. The home insurance buyer hopes for a 0% return on the insurance “investment”… but if the home IS destroyed, that probable loss becomes a very beneficial “trade.”
In this XYZ example, the put options are functioning like insurance just in case the trial is sour and your $500K of stock takes a big valuation hit. If so, you would then harvest your profit on the put options and potentially hang on to XYZ stock for it to eventually come back from this fall.
On the other hand, if it is good news on XYZ, the put options will probably be left to expire worthless… just like the ROI on the home insurance “expires worthless” each year that you do not make any claim.
The magic in this hedge is in selecting the right put options to minimize your cost of the “insurance” while protecting you against much of your potential loss. This is like shopping around for a home insurance policy that will give you the coverage you seek for the lowest price. In this case, you would be shopping around for the right combination of strike price and expiration date at a desirable price.
The difference between complete protection and most of the potential loss on bad XYZ news might be thought of as the insurance deductible… which is a number you basically choose to cover out of pocket before your home insurance policy kicks in. The “deductible” in this XYZ hedge might be set by a choice of strike price being far enough out that you will suffer SOME loss if you have to harvest profit from the options. Why would you choose that? The “insurance” would cost less… just like choosing a higher deductible vs. a lower (or no deductible) on your home insurance. You take on additional out-of-pocket loss in an insurance claim in exchange for a cheaper insurance price.
Since you know the news is going to hit in a predictable period of time, you do not need much time in the put options, which means you could shop for those closer to expiration and thus consider relatively cheap put options. This would be like being worried about something happening to your home in only one season and opting to buy insurance for only that season. Obviously, short-term coverage will cost less than long-term coverage… so a short-term hedge will cost less than a long-term one. Thus, you can buy the downside protection for relatively cheap while still very much having that protection if needed.
SUMMARY OF CORE CONCEPTS
There is a great abundance of other ways to use options in investing, but this lengthy lesson covered a selection of our own favorites. Since it is a long lesson, let us summarize key concepts…
Just like a stock trader, the option trader will:
Unlike the stock trader, the option trader takes on 2 additional tasks:
A stock trader can “be early” or “be late” with minimal consequence because their ultimate card to play is simply waiting out anything that happens. If they wait long enough, just about any trade can end up closing as a winner. Thus, if a stock trader has sufficient patience and money to tie up for up to exceptionally long periods of time, they can enjoy a high win ratio by simply waiting for losing positions to become wins again… even if that might take a decade or longer.
An option trader is ideally buying immediately before the big move occurs and exiting as the big move nears its peak, all within the window of time they chose ahead of the option’s expiration date. An option owner needs big results to occur within a short window of time they control. Even a “stock does nothing” scenario is generally bad for the option holder due to time decay eroding the value of the option. Thus, most option purchases end up as losses because there is almost no flexibility if the trader is wrong about the timing of the move. They simply take their loss and move on to another trade.
In turn, the:
In a worst-case (company bankruptcy) scenario, both the stock and option trader could lose up to 100% of the money they have in each position. This can be sizable for the stock trader but only a fraction of that for the option trader.
In a shorting vs. put buying comparison, both can take profitable advantage of a falling stock price. The put option buyer can harvest almost as much profit as the short seller. However, the risk profile is hard-capped downside risk in the put option vs. theoretical unlimited risk for the stock short seller.
The hedging approach to using put options like buying insurance. This is a trade you do not really want to “win” as it is only a backup to what you think will happen with a big stock position. If you need it, it is there to minimize the pain of the stock taking a dive. If you do not need it, the stock likely rose as hoped and you let the “insurance” expire much like letting an actual insurance policy expire.
There is much more that can learned about options but hopefully, the substantial overview you just read establishes solid foundational knowledge. If you would like to learn even more, consider trying our flagship alert service, in which we share some simple call & put option recommendations each month with detailed, trade-by-trade, educational rationale explaining why we like each trade. One of the best ways to learn anything in trading is by actually trading. Our combination of novice-friendly recommendations with educational rationale is a terrific way to “learn as you earn.” You can lean on Sal’s nearly 40 years of experience helping you succeed while learning from him and our team all throughout the year(s). Check out Sal’s Private Trades.
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