A Beginner's Guide to Calls and Puts Options

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Introduction

Most people know you can make money in the stock market when prices are rising and the economy is strong. But what about when times are uncertain? Instead of staying on the sidelines, you can use alternative strategies to profit during a down market. One effective approach is trading options. While options carry more risk than buying and holding stocks, this risk can be managed with proper planning. Plus, your returns could be much higher than simply relying on appreciating stocks🚀🔥.

What is an Option?

An option is like a special ticket that gives investors the choice to do something with a particular item (usually a stock) at a specific price and before a certain date. It’s a bit like having a superpower—you can decide whether to use it or not! An option is a right, not an obligation, to buy or sell a specific stock at a designated price before a particular date. Options come in two varieties, including calls and puts.

What is a Call?

A call is a type of options contract where the buyer bets that the stock price will increase. The buyer has the right to purchase shares (or “call them away”) at a predetermined price called the strike price. The buyer can exercise this right if they choose.

Imagine you're a fan of a popular band, and they're having a concert. You want to make sure you can get a ticket to see them perform. So, you buy this special ticket called a "call option."

1. The Ticket Price (Strike Price): When you buy the call option, you agree on a specific price (let's call it the "ticket price" or "strike price"). This is the price at which you can buy something later.

2. The Concert Date (Expiration Date): The call option has an expiration date, just like the concert date. If you don't use your ticket by that date, it becomes useless. So, you need to decide whether to use it or not before the concert (expiration) date.

3. The Concert Venue (Underlying Asset): Now, what's this special ticket for? It's not for a concert, but for buying something else—like shares of a company (which are like pieces of the company). These shares are the "concert venue" where you can use your ticket.

4. The Concert Experience (Profit Potential): If the band becomes super popular and the concert venue (company shares) gets more valuable, your ticket becomes valuable too! You can use it to buy shares at the agreed-upon price (strike price). Then, you can sell those shares at a higher market price and make a profit.

5. The Ticket Cost (Premium): But wait, there's a catch! To get this special ticket, you have to pay a fee upfront. This fee is called the "premium."

Remember, the call option is like a backstage pass to the stock market concert. Use it wisely! 🎤📈

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What is a PUT?

In some ways, puts are the opposite of calls. The buyer of a put anticipates the stock price of the option to go down, so they want to lock in the high price before it falls. The buyer of the put gets to sell their shares at a specific price. Puts are often compared to insurance. This will mitigate your loss to just the price of the put’s premium.

Let's dive into how a put option works:

1. The Ticket Price (Strike Price): Imagine you're at a magic show, and the magician offers you a special ticket. This ticket allows you to sell something later at a specific price. We'll call this price the "strike price." It's like saying, "Hey, I'll sell you this magic wand for $10, but only if you want it later."

2. The Magic Trick (Profit Potential): Now, what's the magic trick? Well, this special ticket is for selling shares of a company (the "magic wand") that you don't even own yet! If the company's stock price drops, your ticket becomes valuable. You can use it to sell those shares at the higher strike price and make a profit.

3. The Ticket Cost (Premium): Just like with the call option, there's a catch. To get this magical ticket, you have to pay a fee upfront. This fee is called the "premium." It's like paying for a backstage pass to the stock market magic show.

4. The Showtime (Expiration Date): But wait, there's more! This magical ticket has an expiration date. If you don't use it by then, it disappears like a puff of smoke. So, you need to decide whether to use it or not before the showtime (expiration) date.

In summary, a put option lets you sell something you don't own (company shares) at a fixed price (strike price) by using a special ticket. Use it wisely, and may your profits be magical! 🎩📉

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Common call and put combinations

Calls and puts can be combined in various combinations for several investment goals. Here are a few strategies commonly used by options traders.

Bullish CALL Spread

Let's break down the bullish call spread in a more reader-friendly way:

Imagine you're playing a game with two special cards related to a stock you like. 🃏📈

1. The "Buy Low" Card: You get one card that lets you buy the stock at a lower price (let's say $100). This card is like saying, "Hey, I want to buy this stock if it gets cheaper!"

2. The "Sell High" Card: Now, you also have another card that lets you sell the stock at a higher price (around $110). It's like saying, "I'll sell this stock if it goes up!"

Here's how it works:

- Both Cards Expire Together: These cards have an expiration date, just like a game timer. If you don't use them by that date, they vanish!

- Cost and Protection: The cool thing is that the "Buy Low" card costs you some money (maybe $3), but the "Sell High" card gives you some cash (let's say $1.50). So, your net cost is only $1.50 per share.

- Profit Potential: If the stock price goes up, you can use your "Sell High" card. You'll make a profit of $10 per share (because $110 - $100 = $10). But remember, you spent $1.50 on the cards, so your actual profit is $8.50 per share.

- No Need to Buy the Stock: The best part? You don't even need to buy the actual stock! You're like a stock magician—making gains without owning the shares. 🎩✨

So, with a call spread, you're playing the stock market game smartly. Just keep an eye on that expiration date! 🗓️🚀

Bearish PUT Spread

Let's break down the bearish put spread in a more reader-friendly way:

Imagine you're playing a game with two special cards related to a stock you think will go down. 🃏📉

1. The "Sell High" Card: You get one card that lets you sell the stock at a higher price (let's say $110). This card is like saying, "I'll sell this stock if it goes up!"

2. The "Buy Lower" Card: Now, you also have another card that lets you buy the stock at an even lower price (maybe $100). It's like saying, "I want to buy this stock if it gets cheaper!"

Here's how it works:

- Both Cards Expire Together: These cards have an expiration date, just like a game timer. If you don't use them by that date, they vanish!

- Cost and Protection: The cool thing is that the "Sell High" card gives you some cash (let's say $1.50), but the "Buy Lower" card costs you some money (maybe $3). So, your net cost is only $1.50 per share.

- Profit Potential: If the stock price goes down, you can use your "Buy Lower" card. You'll make a profit of $10 per share (because $110 - $100 = $10). But remember, you spent $1.50 on the cards, so your actual profit is $8.50 per share.

- No Need to Own the Stock: Just like magic, you're making gains without owning the actual shares! 🎩✨

So, with a put spread, you're playing the stock market game smartly, betting on the stock going down. Keep an eye on that expiration date! 🗓️📉

The Bottom Line

This list of options strategies is just the tip of the iceberg. There are countless combinations to suit every stock, investor, and market condition.

Before diving into options trading, beginners should take time to learn and practice paper trading. While the lower cost of options trading can be appealing, it comes with higher risks that need careful management.

If you want to benefit from options trading, consider this online course conducted by Sean Seah, an International Speaker and Best Selling Author on the topic of Investing and Entrepreneurship. He is featured on Channel News Asia, News Papers, Radio and Investment Magazines. He is also frequently invited to conferences and shared the same stage as Richard Branson, Mary Buffett, Gary Vee, Steve Wozniak and many more.

Happy Investing!