Options are similar to futures, where two parties agree to a transaction at a future date for a set price. The difference is that futures are obligations to follow through on the transaction, whereas options are the right to participate in the transaction. In both cases, the goal is to generate short-term income.
Option contract are either "puts" or "calls,” analogous to short and long positions with futures. A put is the right to sell at an agreed upon price (known as the strike price) within a specified amount of time; a call is the right to buy under those terms. As a buyer, you may exercise the option if you want, but as a seller, you are obligated to sell if the buyer exercises their option.
The value of a put increases as the stock or commodity price decreases, for, if the option is executed, you are guaranteed a higher-than-market price for the stock or commodity you are selling. Conversely, the value of a call increases as the price increases, since it represents the ability to buy at below-market prices.
The best-case scenario for sellers of calls and puts is for these options to expire unused. In that case, the seller has received money (the premium for the option) while giving up nothing in return. It is somewhat analogous to running a hotel and receiving money for unused rooms just by selling the right to stay there on a given day.
Calls and puts may be covered or uncovered. The latter are also called “naked” as they leave investors exposed. Here are simple descriptions of these positions:
- Covered Calls – In this case, you own the stock or commodity and are banking on little near-term change in its price. By issuing a call, you are betting that people will be enticed to buy purchase options, but that the asset will stay flat or slightly decrease in value so the options are never exercised. (This is a method to generate additional short-term income on an asset you own.) If the asset price falls slightly, you can offset the loss with the option premium; if the asset price rises slightly, you will have to sell it for below market value but again may offset the loss with the option premium. Where you can lose substantially is if you bet wrong and the asset rises significantly in price.
- Naked Calls – The same principle applies here, except you are selling options on assets you don’t own. The reward is the potential to receive income on something you never purchased. Your risk is extended because there are no premium offsets here. In addition, you run the risk of a huge price increase in the asset, forcing you to buy at a much higher price and sell at the lower, agreed-upon price. Naked calls are sometimes called short calls.
- Covered Puts – If you already own a short position in a stock or commodity, and you expect the price to rise, a covered put would be your choice. If the price does drop, the premium will offset your losses. The profit potential of covered puts is limited to the premiums you receive for the options sold.
- Naked Puts – In issuing an uncovered put, you expect the put to expire with no value. If fortune smiles on you and this occurs, you can keep the premium, which is your maximum upside. However, if this does not happen, you can suffer significant losses. Unlike naked calls, which have nearly unlimited risk, naked puts have a clearly defined risk. However, most brokers will not allow you to place naked calls or puts until you have shown sufficient expertise and understanding of the risks.
Risks for straightforward call and put options are mostly dependent on correctly predicting the price and setting a proper strike price. However, selling calls has the potential for more catastrophic losses — since prices can only drop to zero, but there is no limit on how high they can rise.
There are even more complex variations on options that increase potential rewards but, unsurprisingly, also come with increased risks. If you want to dive into these vehicles, seek the guidance of financial professionals to make sure you have a thorough grasp of the risks and mechanics of the transactions, and whether these strategies are appropriate for your financial situation. Many an investor has learned the hard way that option trading is not for amateurs!