While there are many variations that sound exotic, there are ultimately only four basic moves in the options market: You can buy or sell call options, or buy or sell put options. In establishing a new position, options traders can either buy or sell to open. Existing positions are canceled by either selling or buying to close.
Regardless of which side of the trade you take, you're making a bet on the price direction of the underlying asset. But the buyer and seller of options stand to profit or lose in different ways.
Key Takeaways
- There are four basic options positions: buying a call option, selling a call option, buying a put option, and selling a put option.
- When trading options, the buyer is betting that the market price of an underlying asset will exceed a predetermined price, called the strike price, while the seller is betting it won't.
- When trading put options, the buyer is betting the market price of an underlying asset will fall below the strike price, while the seller is betting it won't.
- Buyers of call or put options are limited in their losses to the cost of the option (i.e., its premium). Unhedged sellers of options face theoretically unlimited losses.
- Spreads with options involve simultaneously buying and selling different options contracts on the same underlying asset.
Buying and Selling Call Options
A call option gives the buyer, or holder, the right to buy the underlying asset at a predetermined price before the option expires. The underlying asset could be a stock, a currency, or a commodity futures contract.
As the name "option" implies, the holder has the right to buy the asset at the agreed price—called the strike price—but not the obligation.
Every option is essentially a contract, or bet, between two parties. In the case of call options, the buyer is betting that the price of the underlying asset will be higher on the open market than the strike price—and that it will exceed the strike price before the option expires. If so, the option buyer can buy that asset from the option seller at the strike price and then resell it for a profit.
The buyer of a call option must pay an upfront fee for the right to make that deal. The fee, called a premium, is paid at the outset to the seller, who is betting the asset's market price won't be higher than the price specified in the option.
In most basic options, that premium is the profit the seller seeks. It is also the risk exposure, or maximum loss, of the option buyer. The premium is based on a percentage of the size of the possible trade.
Buying and Selling Put Options
A put option gives the buyer the right to sell an underlying asset at a specified price on or before a certain date.
In this case, the buyer of the put option is essentially shorting the underlying asset, betting that its market price will fall below the strike price in the option. If so, they can buy the asset at the lower market price and then sell it to the option seller, who is obligated to buy it at the higher, agreed strike price.
Again, the put seller, or writer, is taking the other side of the trade, betting the market price won't fall below the price specified in the option. For making this bet, the put seller receives a premium from the option buyer.
Call and put options have a risk metric known as the delta. The delta tells you how much the option's price will tend to change given a $1 move in the underlying security.
To Open vs. to Close
There are other terms to know when executing these four basic trades:
Buy to Open
The phrase buy to open refers to a trader buying either a put or call option that establishes a new position. Buying to open increases the open interest in a particular option, and increasing open interest can signal greater liquidity and point to market expectations.
Sell to close refers to the time that the holder of the options (the original buyer) closes out the call or put position by selling it for either a net profit or loss.
Note that options positions always expire on the expiration date for the contract. At that point, in-the-money options will be exercised and out-of-the-money options will expire worthless.
There is no need to sell to close if an options position is held to expiration.
Sell to Open
A trader may also sell to open, establishing a new position that is short either a call or a put. A short put is actually taking a long position in the underlying market because put options rise in value as the underlying price declines.
When you sell a naked, or unhedged, option the seller (known sometimes as the writer) is exposed, in theory, to unlimited risk. This is because the seller of an option can see losses mount quickly if a short call position sees a rapidly rising underlying market,
Buy to close means the option writer is closing out the put or call option they sold.
Other Options Terms
In addition to these four basic options positions, traders can also use options to build spreads or combinations. A spread involves buying and selling options together on the same underlying asset. A combination is buying (selling) two or more options. Here are a few basics:
- Vertical call/put spread: Buy (sell) one call (put) and sell (buy) and more out-of-the-money call (put). Vertical spreads that profit in up markets are bull spreads; in down markets they're bear spreads.
- Calendar Spread: Buy (sell) an option with one maturity to sell (buy) an option with a different maturity.
- Straddle: Buying both a call and a put at the same strike and expiration date.
- Strangle: Buying both a call and a put at the same expiration but different (out-of-the-money) strikes.
- Butterfly: A market-neutral strategy involving buying (selling) a straddle and selling (buying) a strangle.
- Covered Call: To sell shares against an existing stock position.
- Protective Put: To buy shares against an existing stock position.
Is Trading Options a Good Idea for a Beginner?
Investing in options is more complex and less straightforward than buying and selling stock.
It also requires the investor to open a margin account, effectively borrowing money that might be lost. This increases the risk to the investor.
Basic options strategies may be appropriate for certain beginners but only if they understand all of the risks as well as how options work.
In general, options that are used to hedge existing positions or for taking long positions in puts or calls are the most appropriate choices for less-experienced traders.
What Is the Difference Between a Call Option and a Put Option?
A call option gives the holder the right (but not the obligation) to buy the underlying asset at a specified price at or before its expiration.
A put contract instead grants the right to sell it at a specified price.
Can I Lose Money Buying a Call?
You can lose money buying a call.
If you buy a call, the breakeven price is the strike price of the call plus the premium (i.e., the price) paid for it.
So, if a $25-strike call is trading at $2.00 when the share price is at $20, the stock would have to rise above $27.00 before it expires to break even. If not, the trader will lose up to a maximum of the $2.00 paid for the contract.
The Bottom Line
Options trading is filled with trader lingo, making it seem more complicated than it is.
When you trade options, you're not buying or selling a real asset like a share of stock. You're making a bet on the way that a stock ( or other asset) will move in the market.
Professional options traders commonly use leverage, meaning borrowed money, in order to multiply their returns on options trades at a relatively small cost.
This is as risky as it sounds.
That said, the options market is regulated by an independent government agency, the Commodity Futures Trading Commission. The agency has oversight over all derivatives markets including futures, options, and swaps.
Options trading is also used to hedge risk in other investments. This is a better choice for investors who don't have an in-depth understanding of this corner of investing.
