Put and call options are some of the most powerful and flexible investment tools ever devised. Unlike the simple purchase of stocks, bonds or ETFs, you can use puts and calls to construct option strategies that have the potential to benefit from any market scenario: bull markets, bear markets or even a sideways market. Expecting a big move but aren’t sure which direction? You can use options to take advantage of this scenario as well.
Used properly, put and call options can help reduce both the risk and the volatility of nearly every investment portfolio for a surprisingly reasonable cost. You can use options as surrogates in just about any asset class for a fraction of the risk of a fully invested position, keeping the money you would have risked buying stocks, bonds, commodities or gold earning interest in safer investments.
Here’s a quick example…As we write this on November 4, 2013 S&P 500 E-Mini futures are trading for 1760, representing an underlying value of $88,000. We could buy a deep-in-the-money call option costing just $3,725 that would give us practically the same upside exposure to the market for just a fraction of the cost and risk.
This is why options are so popular with professional traders. Many investors ignore options because they don’t understand them. Fortunately, when you get right down to it, puts and calls are really not that complicated.
What You Need to Know About Options Puts and Calls
How Calls Work
Call Buyers – pay money – known as a “premium” – for the right but not the obligation to buy an underlying market at a specific price for a limited amount of time. You are not buying the underlying market itself; you are paying for the right to be long that market instead. The call buyer wants the market to go up. The risk of the buyer of a call is limited to the price paid for the option.
Call Sellers – receive money – known as a “premium” – in exchange for granting the right to buy to the call buyer. A call option seller is getting paid up front for an obligation to SELL the underlying market to the call buyer at a certain price for a limited amount of time. The call seller does not want the market to go up. The risk of a seller of a call is unlimited.
How Puts Work
Put Buyers – pay money – known as a “premium” – for the right but not the obligation to sell an underlying market at a specific price for a limited amount of time. You are not selling the underlying market itself; you are paying for the right to be short that market instead. The put buyer wants the market to go down. The risk of the buyer of a put is limited to the price paid for the option.
Put Sellers – receive money – known as a “premium” – in exchange for granting the right to sell to the put buyer. A put option seller is getting paid up front for an obligation to BUY the underlying market from the put buyer at a certain price for a limited amount of time. The put seller does not want the market to go down. The risk of a seller of a put is limited only by the difference between the strike price and zero.
Key Phrase, Option Buyer: The key phrase for both call option and put option buyers is “…but not the obligation.” Since option buyers do not have an obligation to buy or sell, their total risk is the option’s cost plus any transaction fees. That’s it.
Key Phrase, Option Seller: The key phrase for both call and put option sellers is “…get paid up front.” Option sellers get to keep the “premium” they receive no matter what. Option sellers do not expect to have to live up to most of their obligations to buy or sell an underlying market – just as an insurance company does not expect to have to pay off on most of the policies it sells.
Options Behave Like Insurance Policies
Options trade on exchanges, just like stocks. For every buyer of an option there must be a seller. Who is selling put and calls? Other traders and investors. Why sell options? Because, like your insurance company, option sellers get paid up front for an obligation to buy or sell an underlying market. Option sellers do not believe they will have to perform their obligation and will get to keep the money they received.
Do you buy car insurance or homeowners insurance? If so, you are essentially purchasing a put option. You pay your insurance company money in exchange for the right to recover the value of your house or car if it is damaged or destroyed. By accepting your “premium” (notice how the language is the same), your insurance company has an obligation to pay you off in the event of damage or loss. As we mentioned above, the insurance company sells you your policy because it believes it won’t have to pay you off. Meanwhile, it gets to invest your premium dollar in any way it sees fit. Option sellers do the same thing.
You can also think of options this way: when you pay someone to work for you, you are like the option buyer; your money buys you the right to tell your employee what you want them to do. If you work for somebody else you are accepting money in exchange for an obligation to do the work you are given. You get paid whether or not the work assigned to you pays off for your employer. Options work the same way.
Learn More About Options Puts and Calls
If you would like to know more about how options work, click here to download The RMB Short Course in Futures and Options our 30 page, easy-to-follow primer on futures and options – complete with real market examples – absolutely free, or contact an RMB Group professional. Get ready to look at investing in a whole new way.