Basic Call and Put Options Strategies

For options-approved traders, trading options can be useful in a variety of circumstances and in different market scenarios. Some options strategies can be complex, but for options beginners, it might make sense to start with fundamental strategies like basic call and put options.

Like all our strategy discussions, the following is strictly for educational purposes. It is not, and should not be considered, individualized advice or a recommendation.

A call option gives the owner the right, but not the obligation, to buy the underlying security at a specific price (the "strike" or "exercise" price) on or before a specific date (the "expiration").

A put option gives the owner the right, but not the obligation, to sell the underlying security, again, at a specific price on or before a specific date. For standard stock or equity options, each contract delivers 100 shares of stock. Non-standard options may have different deliverables so it's important to understand the terms before trading.

Buying a call option is often considered a bullish strategy because the price of the call option typically rises when the price of the underlying security rises. Similarly, call prices typically fall when the underlying security falls. The premium paid for an option is typically a fraction of the price of the underlying asset. Traders or investors who have a directional view might consider buying a call option as a lower-cost alternative to buying a stock outright.

It's important to remember that options expire, unlike stocks. If a trader buys an option and it expires worthless, they lose the entire investment. Additionally, options don't carry voting rights, and they don't pay dividends.

Some option traders turn to call options when they already own the stock. Instead of using calls as a typically lower-cost substitute for stock, they use calls to potentially generate income on shares they already hold. This strategy is called a covered call¹ and involves selling the option rather than buying it.

When a trader sells a covered call, instead of paying a premium, they receive the premium. However, the call can be exercised at the will of the owner (buyer) of the call option at any time up until expiration. If the call is in the money² (ITM) on or before expiration, the likelihood that the owner of the option will exercise their right to buy the underlying at the strike price increases. If the owner exercises the option, the trader will be required to deliver the stock. Additionally, the short (sold) option can be assigned at any time regardless of the ITM or out-of-the-money³ amount.

Using the data from the table below, let's look at an example. Suppose a trader owns 100 shares of a stock that's trading at $79.34. Assume the trader is bullish for the long term but doesn't think the stock will move much higher over the next several weeks. The trader creates a covered call by selling a call option against the stock.

Looking at the above table, suppose a trader sells the 82.5 strike call at the bid price of $2.37. The trader would collect $237 of premium ($2.37 x 100) minus transaction costs. If the stock stays below $82.50 between the time the trader buys it and expiration, the call would likely expire worthless. If the call option buyer does not exercise the option, the trader would keep the stock as well as the premium. Some traders refer to this as an "income enhancement" to the stock the trader owned.

On the other hand, if the stock rallies above $82.50, the trader might be required to deliver the stock at $82.50 per share. Because the stock was at $79.34 when the trader sold the call option, if the stock rallies above $82.50 by expiration, the return is capped at $553 ($237 premium + $316 stock gain) minus transaction costs. The total return is capped because the trader is required to sell the 100 shares owned, so if they only had 100 shares to begin with, they don't own additional shares of that stock.
 

The protective put is a basic options strategy that can potentially help limit potential losses on a stock a trader already owns. Buying a put option is usually considered a bearish strategy because the price of a put tends to rise as a stock price falls and vice versa. A put gives the owner the right, but not the obligation, to sell the underlying at the strike price at any time up until expiration. If the long put expires worthless, the entire cost of the put position would be lost. This strategy provides only temporary protection from a decline in the price of the corresponding stock.

If a trader is bearish on a stock, they might consider buying a put instead of shorting the stock. Shorting stock might be considered risky because there's no cap on potential losses. The theory behind the protective put is that a trader buys the put option on stock they already own in case the stock drops.

Using the data from the option chain table above, a trader might own the stock but isn't comfortable with the thought of it dropping below $77.50. This concern might be because the trader wants to attempt to protect profits or they might think that $77.50 represents a price support level on the price chart. Whatever the reason, paying $2.76 ($276 per contract) for the 77.5 put means the trader caps their losses at $4.60 if the stock falls below $77.50 on or before the expiration date of the option. That's the difference between the current stock price and the strike price ($79.34 – $77.50 = $1.84), plus the premium for the put ($2.76). And don't forget to add transaction costs.

In this example, the trader has limited their downside risk, but it's still possible to profit if the stock continues to rise.

Although call and put options are used to make directional plays on a stock, it's also possible to use them to potentially generate income and protect stock you own.