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There are only two types of options – calls and puts. It’s really very simple.
The text book definition of an option is as follows:
The right, but not the obligation, to buy or sell a specified asset at a predetermined price over a predetermined time.
While the aforementioned definition is correct, it makes my eyes glaze over each and every time I read it.
My goal is to bring options to the forefront, to dispel the mystery of how they are used and to show you how to use options in an effective and responsible manner. Definitions, like the standard one mentioned above only make options more difficult for the average investor.
Simply stated, options can be bought or sold. An investor who buys an option is long the option. A person who sells an option is short the option. Simple, right? Buy = Long Sell = Short
There are only two types of options: calls and puts.
Every position that is built using options is composed of either all calls, all puts, or a combination of the two. One thing that smart option traders know is that you can sell options as easily as you buy them. That is going to be one of the main themes throughout the Option Advantage service and this theme will be seen directly in the Options Advantage Portfolio. By learning how to incorporate both the buying and selling of options you will be learning the key strategies used heavily by most professional options traders.
So what exactly are call and put options?
Both puts and calls can be either bought or sold, just like stocks. When you “buy to open” an option, thereby paying a debit, you are said to be long that option.
When you “sell to open” an option, thereby collecting a credit, you are said to be short that option.
Most beginners start by just buying calls and puts. One of the strategies I use in the Options Advantage portfolio, the High-Probability strategy, only buys calls and puts. I will go over the details of the strategy in our special report Using Options ETFs for Wealth Protection and Portfolio Growth, but first I want to make sure we have a sound understanding of what it means and takes to buy calls and puts.
Buy a call (long call) Buying a call option – call option buyers hope for higher prices.
The buyer of a call option has the expectation that the underlying security is going to move up. And when I say “underlying security”, I am referring to the stock, ETF, or commodity in which you are trading options on. In our case, ETFs like SPY, DIA, IWM and QQQ fit the bill. A call buyer has the right to control a bullish directional position of long 100 shares of stock per options contract for a specified time (until options expiration) at a certain strike price.
The call buyer essentially pays a fee to the option seller for this right, which is called the “premium”. I will discuss premium shortly.
The following are the characteristics of a long call: Market sentiment – bullish Risk – varies, but has a limited loss potential equal to the price paid for the call option, otherwise known as the premium Time in trade – can vary from hours to several years (I typically hold a long call for less than one week) Winning trade – the underlying ETF advances in value greater than the amount of time value you paid for the option Losing trade – ETF remains stable or declines. If the ETF remains stable you will gradually lose time value which will cause the price of the option to decline. If the ETF declines you will lose intrinsic value and time value will decline the longer you hold the trade which will cause the price of the call option to decline.
Buy a put (long put) Buying a put option – put option buyers hope for lower prices.
Buying put options is the exact opposite of buying calls. The put option buyer has the expectation that the underlying security is going to move lower in price. A put buyer has right to control a bearish directional position of short 100 shares of stock for a specified period of time at a certain strike price level. The put option buyer has a limited loss potential equal to the price paid for the option, but also has an unlimited upside gain potential.
Just like call buyers, the put buyer essentially pays a fee to the option seller for this right, which is called the “premium”.
The following are the characteristics of a long put: Market sentiment – bearish Risk – varies, but has a limited loss potential equal to the price paid for the put option, otherwise known as the premium Time in trade – can vary from hours to several years (I typically hold a long put for less than one week) Winning trade – the underlying ETF declines in value greater than the amount of time value you paid for the option Losing trade – ETF remains stable or advances. If the ETF remains stable you will gradually lose time value which will cause the price of the option to decline. If the ETF advances you will lose intrinsic value and time value will decline the longer you hold the trade which will cause the price of the put option to decline.
Now that you know how to buy calls and puts let’s move to something a little more complex, but certainly not difficult.
The sellers of calls and puts have different views and obligations. Options traders sell options to bring in income. This is included in the special report Using Options ETFs for Wealth Protection and Portfolio Growth.
The seller of a call has a neutral to bearish view of the underlying security (although I take a different stance which I will discuss in a future special report).
The seller of a put option has a neutral to bullish view of the underlying security (again, I will discuss how my strategy of selling options works in a future special report).
I do not sell calls or puts by themselves, otherwise known as selling naked calls or naked puts. I sell what is called vertical call spreads and vertical put spreads for reasons I will discuss in my Options Advantage strategy report.
So simply stated:
Sell a call (short call) Call option sellers hope for stable or declining prices.
Sell a put (short put) Put Option sellers hope for stable or advancing prices
So let’s review.
- Buy calls (debit) = long calls = bullish on the market
- Buy puts (debit) = long puts = bearish on market
- Sell calls (credit) = short calls = slightly bearish to neutral view
- Sell puts (credit) = short puts = slightly bullish to neutral view