Buying and Selling Options

You might buy options to speculate on price movements with limited risk or to hedge against potential losses in your portfolio. Selling options can generate income through premiums or serve as a way to implement various strategies like covered calls. To learn more about buying and selling, please see the sections below.

Selling Options

Covered Calls

Stock options can not only be bought by investors but sold by investors as well. This allows them to generate income by collecting on the premiums paid. Investors who wish to generate additional income in the form of premiums can utilize a covered call option strategy. A covered call strategy is when an investor sells a call option while at the same time holding the underlying stock long position. This option trading strategy limits the upside potential of the investment during the duration of the option. It also eliminates the risk of potential infinite losses if the underlying stock price begins trading higher than the option strike price. However, an option seller is obligated to deliver the stock if the underlying stock price exceeds the strike price as well.

Therefore, an investor who sells a covered call may have their shares sold at the strike price and may no longer participate in any future stock price increases. The risk of losing the entire investment in the stock less the premium collected is also the maximum potential loss.

Cash-secured Puts

Investors who anticipate that a stock won't trade below a certain price for a set time period can generate income by selling a put option. One such option trading strategy is selling a cash covered put option. This entails selling a put at a certain strike price while also posting cash as collateral in case the put option is exercised and shares are obligated to be purchased. The risk to this option strategy is that you may be forced to buy shares at a price above what the stock is currently worth. In addition, this means that the value of the stock you’re obligated to purchase may fall to zero. In addition, you will also have exposure to unrealized losses on the short option until the expiration date.

Purchasing Options

Calls

Purchasing a call option allows you to participate in the upside of a stock. The buyer of call options has the right, but not the obligation, to buy a stock at a specified price. The call option gives you flexibility to own stock later if it appreciates, while not requiring you to invest in it during the interim if it does not. For this, you pay a premium. While there’s upside potential in purchasing a long call option, you can lose the entire amount invested in the long call option strategy. An example:

Suppose a friend tells you about a promising software technology company trading under the ticker IOIO. She believes that with the recent release of their new proprietary coding software, the stock should double within the next 3 months.

Although you know technology stocks can be risky, buying a call option allows you to benefit from potential upside without initially buying the stock.

• Current stock price (IOIO): $10
• Call option strike price: $10
• Call option premium: $2

Total cost of call option (1 contract): $200

Break-even point: For you to break even on your long call option, the stock needs to rise to $12.

Scenario

1. Stock Price Rises to $18:

• Before the option expires, you exercise your call option and buy the stock at $10.
• Total cost to buy 100 shares: $1,000
• Value of the stock: $1,800
• Unrealized gain: $800 (Value of stock) - $1,000 (Cost of stock) - $200 (Cost of option) = $600

2. Stock Price Does Not Exceed $10:

• You lose the initial $200 paid for the option.

3. Comparison to Buying Stock Directly

- If you bought 100 shares at $10: $1,000

- If stock price falls to zero, total loss: $1,000

In summary, buying the call option allows you to participate in the stock's potential upside with a lower initial investment and limited risk, whereas buying the stock directly exposes you to higher potential losses if the stock price declines.

Puts

Hedging

Put options can be a form of insurance for stocks. If your stocks decrease in value during a specific time period, a put option gives you the right to sell your stock at an agreed-upon price. Investors who wish to protect their portfolio’s value will therefore purchase puts in case prices fall. The action of purchasing a put option while holding the underlying security is called a Protective Put.

Bearish

Investors can also buy put options without holding the underlying securities, known as a Long Put Option. This allows for greater flexibility and leverage in a bear market. Conversely, the risk of this strategy is that it may lose value in a relatively short amount of time and incur permanent loss.

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