Trading Options: The Basics You Should Know

Some investors are automatically turned off when they hear the idea of using options. They feel that trading options is too risky.

Yes, options trading isn’t for everyone. It can be risky. If you don’t know what you are doing, you shouldn’t be trading options.

It’s very possible to lose 100% of your investment when you buy an option. By contrast, except in rare cases, you aren’t going to lose everything when you invest in a stock.

On the other hand, when used properly, options can result in quicker and bigger gains than by investing in stocks alone.

If you are considering options as a way to boost your investment return, at a minimum you should know the difference between buying/selling a call and buying/selling a put and the maximum possible gain and loss on each trade.

The Difference Between a Call and a Put

A call option is the right to buy from the option writer (or seller) shares of the underlying stock at the strike price on or before the expiration date specified in the option.

A put option is the right to sell to the option writer shares of the underlying stock at the strike price on or before the expiration date specified in the option.

One option contract is equal to 100 shares of the underlying stock.

When you buy a call, you want the underlying stock price to rise. When you buy a put, you want the underlying stock to fall. The opposite is true when you write a call or put.

Maximum Potential Gain and Loss

The table below summarizes the maximum possible gain and maximum loss for each option trade.

As mentioned earlier, when you buy an option, you could lose 100% of your investment. This occurs when the option expires or otherwise becomes worthless. However, your loss is limited to the premium you paid to purchase the option.

When you buy a call option, your maximum gain is theoretically unlimited because there’s no upper bound to a stock price. In reality, though, a stock won’t go to infinity. If you exercise the option, your gain will be the difference between the strike price and the market price, net of the premium, multiplied by 100. So if the strike price is $50 and you paid $1, and the stock goes to $55, then your gain would be $400.

When you write a call option, your maximum gain is the premium, the cash you received for selling the option, but that money is yours no matter what. In the example in the above paragraph, your loss would be $400. But you could lose more.

Naked vs. Covered

Your maximum loss on a naked call—you write the option without having shares of the underlying stock—is theoretically limitless. Realistically you won’t lose an infinite amount of money, but you can still lose a lot on the trade if the stock moves a lot higher. If that $55 stock jumped to $85, your loss would be $3,400 per contract.

A less risky call-writing strategy is to write a covered call. This is when you have enough shares of the underlying stock in your account to cover the option position. In case the option is exercised, you wouldn’t need to buy shares on the market to fulfill your obligation. You can write calls at a strike price at which you would be happy to sell the underlying stock anyway. You can do this repeatedly and collect the premiums.

The Best and Worst Scenarios for a Put

When you buy a put option, your maximum gain occurs when the stock falls to zero. In this scenario, the maximum gain is the strike price minus the premium you paid and multiply by 100. If the stock fell to zero, the strike price is $50, and you paid $1 per contract, then your maximum gain per contract is $4,900.

When you write a put option, you won’t gain more than the premium you received for selling the option. The worst-case scenario is if the stock falls to zero and it is put to you.

This means you have to pay the strike price for a worthless stock. Your loss is partially offset by whatever premium you received. So if the strike price is $50 and you received $1 per contract, your maximum loss would be $4,900.

(To keep things simple, in all examples I have ignored commissions, which is usually a small base fee plus an incremental per-contract charge.)

In practice, few options are actually exercised. They either expire or the option traders will close out their positions before expiration. Thus, the realized gain or loss is usually the difference between the exit and entry prices for the option. Nevertheless, you should still understand what you could stand to lose.

Experienced traders use many different strategies to manage risks and limit maximum potential loss. I’ve only outlined a few.

To boost your wealth creation, consider the strategies devised by my colleague, Jim Fink. He has found the right balance between risk and reward, to consistently beat the market.

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