Today’s question is based on a follow-up question that I did last week.
I thought it would be just wiser or smarter to do a cover on both of these situations.
The last question we had was all about the difference between buying and selling a call and put.
I did this video almost four or five years ago, and people watch it like crazy.
I had a question from Joe Simon: “What’s the difference between selling a call and buying a put?”
I answered this question the previous week. And what I wanted to do this time around was talking about actually buying a call and selling a put. What’s the difference?
Take a look at the video from the past: Stock Options: Difference in Buying and Selling a Call or a Put
In this post, we’re going to go more specifically onto buying a call versus selling a put.
It’s a follow up to the previous one,
Buying a call is probably the easiest thing that people think about or do when it comes to trading options.
When you buy a call, this is the risk profile picture that you’ll see. And if you don’t know what a risk profile picture is, here is your profit and loss.
When you look at it, this is your zero line meaning you don’t make money or lose money at this point at expiration.
This is our expiration line. And here is your current T plus zero line meaning that as the stock wiggles up or down. And here is our stock price.
This could be $60, $80, $100. In this case, when you buy a call, there are a few things that happen.
You have unlimited profit potential. That’s the name of the game when it comes to buying a call, unlimited profits. That’s why people like this.
The downside is you lose if the stock stands still. Why is that? Well, if you’re right here and the stock stands still with time, this gets closer and closer to expiration.
That means you have your theta decay or theta burn.
Stock stand still, you lose money.
The stock goes down, and you lose money.
When you’re buying a call, you want the stock to go up. The stock goes up, and it’s got to go up quite a bit to compensate for the theta burn. That’s where you make money. That’s what happens when you buy a call.
When you usually buy a put, you go this way.
You’re making money as the stock goes down. Here’s our line, and here’s our stock price ($30, $40, $60), and here’s your zero line.
You make money as the stock goes down. You would think when I sell a put wouldn’t it be like buying a call because wouldn’t I make money profiting.
But no. That’s not the case because the graph is flipped on you. In this case, it’s going to flip this way. This is buying a put. This is selling a put.
In this case, buying a call – this is buying a call.
Selling a call, you would do the angle this way.
This would be the selling call, and this is the buying call side.
Well, it’s going to look like this.
That’s what it looks like when you’re talking about selling put. Your zero line is going to be like there.
There’s your zero line. You still have your stock price down here. But you don’t have unlimited profit.
Why would someone sell a put?
A lot of people would say that’s stupid.
If I buy a put, I can make unlimited to the downside. Well, why the heck would I sell a put? What’s the point?
Well, the difference is on the left; if the stock stands still, you don’t make money.
And here stock stands still, you make money.
The stock goes up, and you make money.
In both situations, you make money when the stock goes up. That’s because this is going this way to the right is the upside. So you make money in both situations if the stock goes up.
The difference here is you make a flat amount, but you make money when the stock stands still. The stock stands still, you make money. The stock goes up, and it makes money. The stock goes down, you lose.
Here you’re winning two out of three situations in a way (on the right).
On the left, if stock stand still, you lose because you lose from the theta burn the money every day that you lose from the option decaying. The stock goes down, you lose, and the stock goes up, and it’s got to go up quite a bit, and in that case, you make money.
Here you’re only winning one-third of the time or chances.
I’ll give you one example. We’re going to use SQ – Square.
We’re talking about buying a call, and I think this stock is going to explode to the moon. Right now, it’s $61 a share. Buy a single, analyze the trade, and here are my thoughts.
It’s going to explode to the moon. There is my call option. The problem with this call option is this theta that is -2.62.
I lose $2.62 every single day at a standstill. If I go a little closer, let’s say I did a different option contract that’s 65, I lose more than that. I lose $3.71, so depending on the option you’re trading that theta burn kicks in much more in different situations. But you make an unlimited amount. Stock stand still, you lose. The stock goes down, you lose.
The stock goes up, and it’s got to go up quite a bit in fact up until this point.
Here’s your zero line. If I zoom in, you’ll be able to see that. There is our zero line right there.
It’s got to go up way past that. In our case right now, the stock price is 62. It’s got to go past 66 at expiration for us to make money.
Whereas if I sell a put (which is called selling a naked put or selling a naked contract) here stock stands still and I make money. The stock goes up, and I make money. The stock goes down even if it goes down a little bit; I make money.
And it’s got to stay above basically my selling price at 55 for me to lose. Now, remember that the white line is today, and with time now, you’re making positive theta.
As I move the days forward, that white line gets closer to the green line. If I’m talking about buying a call – same thing. With time that white line gets closer to the green line, you see you’re losing. In this case, you’re losing $126. If I sold the put, I’m making $107 or so at this point.
That’s the difference. If stock stand still, you’re making money on the selling side. That’s because you’ve already sold it. You have to let it expire. It’s like paying your insurance company. They’ve already got your money. They have to wait for you to not get into a car accident, then it’s free money for them. That’s the difference.
The problem you have is unlimited loss in this case. What usually people do is they take that 55, and they’ll buy something to protect it at 50. And now you cap it at that 50 right here. And you create a vertical.
That’s ultimately the difference between buying a call and selling a put. One, you do have unlimited profit potential to the upside with a call. But what’s the chance of stock exploding to the moon. It’s slim. It does happen, but it’s slim. That’s why a lot of traders sell premium most of the time. And then they buy the others for protection.
In this case, you’re making money as things standstill. And they can wiggle around there all day long, and you’re still going to collect your money day in and day out or month in and month out.
I hope this post opened your eyes when it comes to buying a call vs. selling a put.
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