Abstract: We use simple words and graphs to explain the four basic option strategies including long call, short call, long put and short put along with practical examples and illustrate some important concepts and operating strategies of options.
What is option?
Simply put, option provides you with the right to buy or sell a target (maybe a stock or any commodities, but we refer to stock options hereafter) at a certain price before a certain date. Therefore, options include the main factors as follows:
- Expiration date
- Exercised price (strike price)
- Buy (call) / sell (put)
Call options
In order to finish a transaction of an option, there are at least a buyer and a seller. For example, there is an Investor A who would like to buy the call option of Alibaba Group (HK stock code: 9988) with expiration of January 1, 2022 and strike price of HK$230. This type of option strategy is called “long call”. As shown in the following graph, the stock price of Alibaba is HK$220 now.
Alibaba stock 52-week chart
Firstly, the reason why Investor A decided to use long call is because he thinks Alibaba’s stock price will rise to more than HK$230 by January 1, 2022. Secondly, there must be an Investor B who sells that call option to order to finish the transaction and this process is called “short call”. But Investor B just thinks reversely as Investor A in which Investor B does not believe Alibaba will perform very well and at least not exceed HK$230 by the expiration. This is actually a bet between Investor A and B. In addition, the one who is on the “long” side needs to pay an option premium to the “short” side counterpart for obtaining the right to execute the buy order at the specified strike price by the specified expiration. In the example above, after the option transaction, Investor A has to pay the option premium to Investor B so that Investor A obtains the right to buy the Alibaba shares at the strike price of HK$230 by January 1, 2022. Here, the amount of option premium is determined by the market conditions and the bid-ask price marking processes between option buyers and sellers. If after the transaction period of January 1, 2022, the stock price of Alibaba rises to HK$280, Investor A may execute the call option to buy the Alibaba shares at HK$230 and so earns HK$50 per share.
Number of shares for a stock option contract
Regarding Hong Kong stock options, a stock option contract is for one lot or multiple lots of shares. So you have to watch it carefully when you place an order. On the other hand, regarding the US stock options, a stock option contract is for 100 shares, it is crystal clear. Moreover, the transaction volume and liquidity of the US stock options is much greater than that of HK stock options. Of course, it will have no problems if you trade options for some hot sale HK stocks.
Put options
Let us look at another situation but still using the Alibaba example above. Its stock price is HK$220 now. If there is an Investor C who heard some bad news about Alibaba and so he believes Alibaba’s stock price will have a significant drop in the short term. So Investor C decided to buy the put option of Alibaba with strike price of HK$200 and expiration of September 1, 2021. In other words, that is a 10% drop within 2 months. This strategy is called “long put”. At the same time, there must be another Investor D which sells this put option to Investor C, that is “short put”. Conversely, Investor D has faith in Alibaba shares. If the stock price of Alibaba really falls to HK$180 after two months, Investor D will have to buy the stock from Investor C at HK$200, in this case Investor C will earn HK$20 per share from the difference between the market price (HK$180) and the strike price (HK$200).
Four basic option strategies
Those are the four main characters today, let me sum up here, they are long call, short call, long put and short put.
Difference between long call and short put
I think you may get a bit confused now. If both “long call” and “short put” are bets on rising stocks, why do we still need both of them and what are their differences? The answer is that they are in fact completely different though they also bet on rising stocks. On the one hand, the loss of long call is limited while its profit can be unlimited. On the other hand, the earning potential of short put is limited while it may cause a huge loss. These are the main differences. Let me explain in detail. If you do long call, the worst case scenario is that you lose all the option premium. However, in the best case scenario the upside can be really unlimited especially for some long term expiration options. For instance, some loyal fans of Tesla (US stock ticker: TSLA) believes its stock price must rise to over US$750 by 2023, they might open long call for Tesla stock with strike price of US$750 and expiration of 2023. Of course, when you are choosing which option strike price to trade, the more out of money the option strike price is, the lower option premium is required, it is due to the lower probability of the option being exercised. I will explain what is out of money and in the money later in this article. Anyway, the stock price of Tesla may finally rise over US$1000, US$1500 or even US$2000 by 2023 as you can see how Tesla performed in the last two years. I know many people have earned a huge sum of money from Tesla stock option using long call these years. That is why I said the upside of long call can be really unlimited.
Source: seekingalpha.com
On the other hand, if you open a short put, the most you can earn is the option premium, that is limited. However, you may suffer a great loss for the downside, but keep in mind that the loss will not be unlimited because the stock price is not likely to drop to zero, even if it does, you will at most suffer a 100% loss. In the short put example above, the strike price is HK$200, if the stock price drops to HK$180 on expiration, you will still have to exercise the option to buy the stock at HK$200, then you look like to lose HK$20 per share. However, this loss is just on the book, not a realized loss; unless you sell it immediately to cut the loss, then the loss is realized. Therefore, you just buy the stock at a price that is currently higher than the market price. However, if it is a stock of a nice running company, its stock price may rise back high one day.
Difference between long put and short call
For the same reason, both “long put” and “short call” are bets on dropping stock prices. For long put, its loss is limited while it may potentially earn a lot. But for short call, earning potential is just limited while the loss can be unlimited. I guess you may be clearer this time. Regarding long put, the most you can lose is the option premium. But if it really goes down significantly, you can certainly earn a large amount of excess over the strike price. However, short call is a different story. First, its earning potential is at most the option premium. Second, if the stock price happens to rise dramatically like how Tesla performed last year after you open the short call, you will unfortunately suffer a huge loss. This loss can be unacceptably huge. As you know, stock prices can rise many times while the loss is at most just 100%. Therefore, you have to be exceptionally careful when opening short call. In my opinion, this is the most dangerous one out of the four option strategies.
In the money and out of the money
Next, let us learn about what “in the money” (ITM) and “out of the money” (OTM) are, they are the fundamental concepts. Simply put, OTM means the stock price does not reach the strike price while ITM means the stock price already reaches the strike price. In the case of call option, if the strike price is $100, any stock prices over $100 is called ITM and it is OTM when stock prices are less than $100. Conversely, for put options, if the strike price is $100, any stock prices less than $100 is called ITM and it is OTM when stock prices are more than $100. In addition, the more OTM it is, that means the farther the stock price is from the strike price, the less amount the option premium is, this is because it will have less probability to be exercised. Conversely, the closer the stock price is from the strike price, that means higher probability the option will get exercised, the more expensive the option premium is.
Time value of option
Time is a critical concept in option trading. Simply put, time is equal to money in options. The closer the expiration is, the cheaper the option premium is. Why is that? Because if there is still a long time to reach expiration, the higher uncertainty there is, the higher probability the option will get exercised. That is why the premium is more expensive. Nowadays, some people especially like to trade the options that are about to expire, because they are really cheap as there is not much time value in it. They are looking for opportunities to bet on any sudden changes of direction or market sentiments. If you buy them and are lucky enough to encounter any sudden turnarounds, you can make a lot of money because of the large volatility, but this is no different from gambling. I really do not recommend it.
My option trading records
I am going to finish it here this time. I have mentioned some fundamental knowledge and concepts about option trading. And I will talk about some other more advanced topics on options. May I remind you again that the volatility of options can be extremely high, so you have to think about it carefully and understand exactly what you are doing before you start trading options. Otherwise, it may turn out to be pure gambling, rather than investing. I recommend that you may have a look at the option trading that I did in my “Trading records” in which I explained the strategies and reasons why and how I did.
Comments and sharing
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