Options 101
Options 101
Some Basics On Derivatives & My Preferred Strategies
Summary
Options are a useful tool for experienced investors. They can be used to speculate or generate additional income depending on the strategy.
I talk about the basics of buying and selling calls and puts, and different strategies available to investors.
I talk about the put options I sold on Peabody Energy BTU 0.00%↑ and my strategy behind the trade.
This post should be a good introduction to options and a reference for future posts where I discuss options that I own.
While I was writing my article on Peabody Energy, I realized that I should explain the put options I sold on the stock a couple weeks ago. I am by no means an options expert, but I know enough to avoid complicated options strategies that have the potential to blow up in my face.
If you are familiar with options, feel free to skip this post. This won’t be anything revolutionary for you. My goal is to provide some of the basics on derivatives, buying and/or selling puts and calls, and my preferred strategies. Options can be used to speculate or generate additional income depending on the strategy. There are options strategies for every risk tolerance and I go over some of the basics below. This should be a good introduction to options for readers that aren’t familiar with derivatives.
There is nothing wrong with buying shares of a company instead of making a leveraged bet on the stock with options. Most of my portfolio is in shares of different companies, but I do make an occasional smaller bet on companies using options. When you buy shares of stock, investors win when the price goes up. When you start using options, you have to be right about the timing, direction, and the size of a change in a stock price.
I’ll start by talking about the basics of call options and put options and wrap up by talking about a couple of my options position to illustrate the potential of different strategies. I want to make it crystal clear that most options strategies carry more risk than just owning shares of stock, and chances are that it won’t make sense for most people. I wanted to write a post for readers looking to understand the basics of options so I can point to it in the future when I’m writing about companies where I own options.
Each options contract is tied to 100 shares of a stock (or ETF, etc.) and has a set expiration date. You can either be a buyer or seller of puts or calls depending on your view of a stock. For an example, I will use part of Peabody Energy’s July 21st, 2023, option chain because I have already covered the company.
Buying Calls
If you are buying calls, you are betting that the share price will be higher than the strike price at the expiration date. If I buy a $30 contract for $0.38, I’m buying the right to buy 100 shares of Peabody for $30 between now and the expiration date. If the market price of shares rockets to $40 in our example, I can still buy 100 shares for $30. If this happens, the value of the call options increases exponentially. If shares stay below $30 between now and expiration, the call option will expire worthless.
The cost of call options decreases significantly as you go farther above the current share price (the $30 contract is cheaper than the $28 contract for example). The higher the strike price, the higher the chance is that the contract will expire worthless. The OTM (out of the money) call options where the strike price is greater than the current price are riskier and cost less per contract, but they have the most torque if the underlying stock goes up. ITM (in the money) call options, where the strike price is below the share price, don’t have the same upside but they aren’t as risky.
There are factors like time decay and other issues with options that I won’t get into here, but when I’m buying calls, I typically prefer to go out as far as possible, pushing the expiration date out 1-2 years. Buying calls is a speculative strategy, but you can generate outsized returns if you get it right. There are other strategies using calls that are more conservative, like the covered call strategy.
Selling Calls
If you are selling calls, you are taking the other side of the trade. If I sell the $30 contract for $0.38, I am selling the right for someone else to buy 100 shares of Peabody for $30 between now and expiration. If I already own 100 shares of Peabody, this is the covered call strategy. It’s one of the safest options strategies and is used to generate additional income. If I don’t already own 100 shares of Peabody, this is called selling naked calls, which carries way more risk of blowing up. If I sell naked calls, and shares go to $40, I have to go buy shares at the market price to sell them at $30 to fulfill the contract.
The same changes in the price of the call options applies here, but by selling calls I’m on the other side of the trade. A covered call strategy might be a good way to add income if a stock doesn’t pay a dividend or if there is a price you are willing to sell shares. If I’m fine selling Peabody at $30 between now and July 21st, I can sell a call option, receiving $0.38 up front. If shares stay below $30, the option expires worthless, and I keep the premium. If the shares are above $30, I have to sell my shares for $30, despite the higher market price. Basically, selling covered calls is a strategy the caps your potential upside to generate income. I use this strategy occasionally (once or twice a year), but it is not a strategy I use often.
Buying Puts
While calls are contracts with the right to buy, put options are contracts with the right to sell. If I think Peabody is going to go down in share price, I can buy puts instead of shorting the stock. I can buy the $20 put contract for $0.67, which gives me the right to sell 100 shares at $20 between now and expiration. The value of these puts will rise dramatically if Peabody shares drop. If shares stay above $20, the put options expire worthless.
If you flip the paragraph about the price of call options on its head, it applies to the cost of put options. The cost of put options decreases significantly as you go farther below the current share price (the $20 contract is cheaper than the $23 contract for example). The lower the strike price, the higher the chance is that the contract will expire worthless. The OTM (out of the money) put options where the strike price is lower than the current price are riskier and cost less per contract, but they have the most torque if the underlying stock goes up. ITM (in the money) put options, where the strike price is above the share price, don’t have the same upside but they aren’t as risky.
I buy puts occasionally, but this is rare. I usually go out 6 months or more, but this is a speculative strategy just like buying calls. I actually have a couple stocks on the watchlist where I might buy puts in the next couple weeks, but I prefer selling puts to buying them.
Selling Puts
Selling puts is one of my favorite options strategies. It works well with stocks that you wouldn’t mind buying at a certain price. By selling put options, I am agreeing that I will buy shares at the strike price in exchange for the premium upfront.
This one we can actually use the real example for Peabody’s July 21st option chain. I sold $30 puts a couple weeks ago, receiving $7.00 for each contract. If shares stay below $30, I will increase the number of shares I own of Peabody by 50%. This is only if I don’t buy back the put contracts before expiration. I plan to buy to close these contracts at some point, but we will see what happens with the share price and the price of the contracts. Either way, I will be writing a trade alert on it at some point by July. If shares go above $30, I keep the $7.00 option premium.
I use this strategy more frequently, but it really depends on what is going on with markets and the stock. This is less speculative, but it is a strategy that works best if you are fine owning the stock. You can generate income from the strategy similar to the way covered calls works.
Conclusion
I know that this is a long explanation for something that might not be remotely interesting for readers. Buying shares is simple and using options is not. Options can increase your risk and reward depending on how they are used, but they can juice your returns if they are used right. They can also blow up your account if they are misused, so consider this your caveat emptor.
I just want to be able to point to a post giving some information on options for readers that don’t understand when I talk about puts or calls in future posts on companies. Without this background, parts of future posts might sound like another language. I think I have provided a good level of basic information on options, but if you have any questions, feel free to leave a comment or send an email.
Disclaimer
I own shares and short puts of Peabody Energy BTU -0.76%↓. Nothing discussed here is an investment recommendation. You should do your own research before making any investment decisions. Each investment discussed has different risk & reward profiles that might not be suitable depending our your situation.