What Are Options?
Options (Option) represent contractual rights that grant holders the authority to buy or sell underlying stocks at predetermined prices (strike prices) before specified expiration dates. In the U.S. markets, these rights are tradable securities where the transaction price is termed the premium.
Types of Options
U.S. stock options are categorized into two primary types:
- Call Options (CALL): Provide the right to purchase stocks
- Put Options (PUT): Provide the right to sell stocks
This creates four fundamental trading strategies:
- Long Call: Buying call options
- Sell Call: Shorting call options
- Long Put: Buying put options
- Sell Put: Shorting put options
Key Option Concepts:
| Term | Definition |
|---|---|
| Expiration Date | Final date the option can be exercised |
| Strike Price | Predetermined price for buying/selling the stock |
| Premium | Market price of the option contract |
Classification by Strike Price
Options are further classified based on the relationship between strike price and current stock price:
Call Options
- Covered Call: Strike price > stock price
- Naked Call: Strike price < stock price
Put Options
- Covered Put: Strike price > stock price
- Naked Put: Strike price < stock price
This distinction is crucial as the strike-to-stock price ratio significantly impacts risk profiles and potential returns.
Leverage Effects in Options Trading
Long Naked Call Example
Consider stock trading at $100:
- Buying a $50 strike call with $60 premium
50% Price Increase ($150):
- Option return: +67%
- Stock return: +50%
50% Price Drop ($50):
- Option return: -100%
- Stock return: -50%
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Long Covered Call Dynamics
For stock at $100 with $110 strike call ($10 premium):
- 50% Price Jump ($150): +300% return
- 10% Rise ($110): -100% return
- No Increase: -100% return
Hedging With Options
Institutional investors frequently use options for portfolio protection:
- Short Sellers may use Long Covered Calls to cap potential losses
- Stock Holders can employ Long Naked Puts to hedge against declines
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Value Investing Strategies
Strategic Selling Approaches
Sell Naked Put for Accumulation:
- Target 10% below current price
- Collect premium if prices rise
- Acquire shares at discount if prices fall
Sell Covered Call for Disposition:
- Set strike 10% above current price
- Earn premium if prices stay flat
- Exit position at target price if reached
"Options are the most valuable insurance policies for disciplined investors." - Warren Buffett
FAQ Section
Q: What's the maximum loss when buying options?
A: Limited to the premium paid for the contract.
Q: How does time affect option values?
A: Premiums decay as expiration approaches (time value erosion).
Q: Why sell options instead of buying?
A: Selling generates immediate income but requires collateral and carries assignment risk.
Q: What's the breakeven point for calls?
A: Strike price + premium paid.
Q: How do dividends affect options?
A: Expected dividends are priced into premiums, especially for calls.
Q: What's assignment risk?
A: The possibility of being required to fulfill the option contract terms.
Key Takeaways
- Options provide strategic flexibility for speculation or risk management
- Strike price selection dramatically impacts risk/reward profiles
- Selling options can enhance value investing strategies
- Proper position sizing is crucial in options trading