Options are widely misunderstood, largely because of the jargon used in the industry. Following are some of the definitions and principles every potential options trader needs.
There are two types of options: calls and puts. Both are contracts, meaning they contain specific rights. A call grants its buyer the right (but not the obligation) to buy 100 shares of a specified stock (the underlying security) at a specified price (the strike) on or before a specified date (expiration). A put is the opposite. It grants its owner the right to sell 100 shares of the underlying at the strike and by or before expiration.
If you buy an option, you can close it at any time in the same way that you sell stock. You just enter a “sell to close” order. You are never at risk for any amount beyond the amount you pay (the premium) for the option.
You can also sell options. Unlike the more familiar long position involving the series buy-hold-sell when you short an option, the sequence is sell-hold-buy. A short call can be very risky or very conservative. It is risky to just short the call because in theory a stock’s price can rise indefinitely. So an uncovered call (also called a naked call) is high-risk. For example, if you sell a call with a 30 strike (meaning the exercise occurs at $30 per share), but the stock price rises to $50 per share before expiration, you are on the hook for the difference between $30 and $50, or $2,000 (remember, every option relates to 100 shares). The main advantage of selling an option is that you get cash at the time you make the sale.
A much safer strategy is the covered call. This involves selling a call when you also own 100 shares of the underlying stock. In the event of exercise, your 100 shares are called away. You profit in three ways: First, you get a capital gain on the stock (assuming you were smart and sold an option with a strike higher than your original cost). Second, you earn all dividends while you own the stock. Third, you get to keep the option premium.
If you sell a put, you cannot really cover it unless you are short 100 shares of the underlying stock. A naked (uncovered) put is less risky than the opposite, uncovered call. This is true because a stock’s price can only fall so far. Some think the maximum risk is zero, which occurs only if the stock becomes completely worthless. But to be practical, the real risk is the difference between the put’s strike and the stock’s tangible book value per share, less the put premium. For example, for sell a put with a 30 strike and get 3 ($300). The stock’s tangible book value per share is $18. Your maximum risk in selling this uncovered put is the net difference between $30 and $18n ($12 per share), or $1,200 for 100 shares; minus the $300 you got for selling the put. So your risk is $900. However, if you think it is unlikely that this stock will drop to its tangible book value per share, the risk is actually much lower.
The attributes of each option – type (call or put), underlying security, strike price, and expiration date – are collectively called the terms and all listed options contain these terms. The terms cannot be changed or replaced, making the market orderly and reliable. Like any language, the language of options is not easy to master, but with practice it becomes easier.