How to Use Puts & Calls

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Covered Call
Covered Call (Image: http://www.theoptionsguide.com/images/in-the-money-covered-call.gif)

Puts and calls are both options to sell or buy an asset in the future. Most commonly, these options are used with stocks as a way to hedge against losses or speculate on the direction of the price. Knowing how to use these financial instruments can help to save money and maximize profits on your portfolio.

Diagram the mechanics of a put option. A put gives an investor the right to sell a stock at a certain price in the future. If you buy a $50 Put on Company A and that company is trading at $60 on the day of expiry, you just made $10 for every put owned on the stock.

Diagram the mechanics of a call option. A call gives an investor the right to buy a stock at a certain price in the future. If you buy a $50 Call option on Company B and that company is trading at $40, you just made $10 for every call owned on the stock.

Track volatility (vol). Volatility is a measure of price fluctuation. Stocks with high volatility will also have larger swings in put and call prices. The value of a put or call option is directly tied to the time to expiry and the volatility of the underlying asset.

Develop a strategy. What is it that you want to do? If you want to hedge your portfolio, you should buy an option that benefits from a loss of profit in your portfolio. That is, if you buy 300 shares of Company A, you might also buy 300 put options (options to sell). You can also sell call options on the stock (covered call). Both establish an equilibrium. If speculating, the task is more complex.

Develop a speculative strategy. Speculating is, at best, an educated guess. Which way do you think the stock price is going to move? You can "take a bet" on that guess by buying a put or call option or both, depending on your needs. Now that you know what each one can do, you can structure your own products.

Consider other put and call strategies. There are numerous options strategies, including the butterfly, collar, variable pre-paid forward, strangle and naked put. Look at each one and diagram your profit/loss potential.

Tips & Warnings

  • The intrinsic value of options are valued with a formula called the Black Scholes Option Pricing Model.
  • Don't forget to include transaction costs. Certain option strategies require three trades, which requires six transactions in total. This is not to be construed as investment advice.

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