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Options: The Long and Short

05/08/2020

Last week we discussed options and went through a few basic analogies to help you understand them. Today we’re going to discuss put options, and what it means to be “long” and “short” .

Quick recap: a call option gives an investor the ability to speculate about a position without buying it outright.  If you think a stock is going to increase in value, you can purchase a call option: you pay a small premium and have the right, but not the obligation, to buy shares of that stock later on at a set price if the stock price exceeds the strike price of the option.

A put option is the opposite of a call option.  If you have a bearish view of a stock, and believe that it will decrease in value, you can purchase a put option.  Again, you pay a premium to the seller, and you have the right to sell a certain number of shares of the stock to the seller at a fixed price.  So if you think stock ABC, which is trading at $100 right now, is going to plummet, you might choose to buy a put option for $1 per share at a strike price of 97.  If you are correct, and stock ABC goes down to $80, you have the right to go out and sell 100 shares for $97 each.  In this case you would profit $1600 ($1700 minus the $100 premium paid).  Note that while the potential upside of a call option is unlimited – theoretically, a stock’s value could skyrocket into the millions – with a put option, there is a limited profit you can make, because a stock’s value can’t decrease below zero.  In our example, the most you could make is $96 per share, or $9600.

The “short” and “long” terminology surrounding options can be confusing, but once you get the hang of it, it’s easy to understand.  Imagine you receive a coupon in the mail to buy a Jen and Barry’s ice cream cone for $3.  The cones usually cost $6, so this would be a good deal if you were craving some ice cream.  If you are in possession of the ice cream coupon, you are “long” the coupon and have the right, but not the obligation, to buy one ice cream cone at Jen and Barry’s for $3 until the coupon expires (now, we know you wouldn’t pay for an ice cream coupon – it would probably be given to you for free.  But our analogy still stands).  Since you are holding the coupon, that means you have the right to use it, and this is the role of the long position.  The ice cream store owner would be “short” the coupon and has an obligation to sell you the ice cream if you choose to use your coupon.  If the coupon has not yet expired, the store owner must honor the coupon price.  They must sell you the ice cream for $3.Now, let’s say you get married and you decide to buy insurance for your wedding band.  If you buy a ring insurance policy you are “long” the policy and have the right to “put” your ring back to the insurance company.  The insurance company is “short” the policy; it receives money in exchange for the potential obligation of having to buy your ring from you.  Whether you make a claim or not, the insurance company keeps your premium, just like you will if you choose to sell options.  That’s its compensation for accepting the risk.  In the real world of ring insurance, you can’t just force the company to buy the ring back.  There are certain conditions that must be met.  The ring would probably have to be damaged or stolen for the policy benefits to kick in.  You certainly can’t just decide that you don’t like your ring anymore and force the insurance company to buy it back.  But in the real world of put options, you can sell back your stock at a fixed price for any reason while the contract stands as long as the price is below the strike price.  Our main point here is that when you are long a put option, you have the rights – the “option” – to decide what to do with it. 

Option trading entails significant risk and is not appropriate for all investors. You need to complete an options trading application and get approval on eligible accounts. Option investors can rapidly lose the value of their investment in a short period of time and incur 100% loss prior to and by expiration date. Please read Characteristics and Risks of Standardized Options before investing in options.

source: https://www.webull.com/blog/35-Options-The-Long-and-Short