The Risks and Rewards of Buying and Selling Options

Plus, why option premiums are so important

Digital Content Manager
Mar 15, 2019 at 2:09 PM
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    While trading options can be a profitable practice for "vanilla" bulls and bears, these investment vehicles can be traded to fit almost any outlook on a stock. Today, we will discuss the specifics of buying and selling options, and the underlying objective, maximum profit potential, and risk of each trading strategy.

    Buying and Selling Put Options

    Typically a trader who is speculating with put options is seen as bearish. However, betting on a stock's direction with puts can go one of two ways. When buying put options, a "vanilla" trader is expecting to profit off the stock's decline. In this scenario, a profit is made when the stock drops below the strike price (minus the premium paid) before the contract's expiration. Maximum risk is limited to the initial premium paid for the options.

    Meanwhile, buying protective puts is a way to protect a trader's existing portfolio. This kind of put buying is often used by shareholders who expect long-term upside for a stock they already own, but are uneasy about the stock's short-term volatility. Upcoming earnings, for example, could prompt traders to buy protective puts. The purpose of these contracts isn't necessarily to bet on the stock's demise, but rather to hedge their bullish bets by securing a profitable exit price (the strike price) if the trade doesn't go as expected. 

    Put selling, on the other hand, occurs when the trader thinks the underlying stock will remain above the strike price through expiration. In this strategy, the seller profits off the premium received at initiation, should the stock remain north of the strike. However, there is significant risk involved, since the put sellers are obligated to buy the shares at the strike price before expiration, if assigned.

    Buying and Selling Call Options 

    "Vanilla" traders who are buying call options are betting on the stock to rally above the strike price (plus the premium paid) before the contract's expiration. This is seen as  the closest thing to simply purchasing the shares. However, long calls can often provide more leverage than buying a stock outright, as the maximum risk is limited to the initial premium paid, while the maximum reward is theoretically unlimited.

    Long call options -- particularly those that are out-of-the-money -- can also be used by short sellers as a way to limit the risk on their bearish bets, should the underlying stock not perform as expected. The long call gives traders the right to buy the shares at the strike.

    On the other hand, traders can sell call options when they believe the underlying stock will remain below the strike price through expiration. Like selling a put, the trader receives an up-front premium and hopes that the option will expire worthless; the premium represents the maximum profit potential. This is why most call sellers look for areas of resistance on the charts that may coincide with a particular strike.

    However, a margin requirement must be paid to a broker when entering the position to cover any potential losses, since short calls tend to be very high-risk. If assigned, call sellers are obligated to sell the stock at the strike price.

    The Importance of Option Premiums

    That being said, traders should be aware of implied and historical volatility numbers. In other words, premiums tend to go up ahead of potentially volatile events, such as company earnings. Option buyers like to see contracts with low volatility expectations being priced in, as this makes for cheaper premiums (and therefore lower risk). Option sellers, meanwhile, typically like to target higher-priced options to maximize their potential reward.

     

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