Puts and calls can be both bought or sold. A call is the right, but not the obligation, to buy shares of a company at a certain price up to a certain date. For example, 3M at the time of writing is $200 per share. Calls expiring on January 21, 2022, with a strike price of $200 can be sold or purchased for $10 per share. This is a five per cent premium for five months.
Buying calls
An investor with limited cash in an account excited about the prospects of 3M could pony up $1,000 for a 100 share call contract, and with this small investment effectively have the upside of 3M until the expiry date. This sounds enticing but if the price of 3M fell below $200, the options would expire worthless, and the investor would lose $1,000. If the price ranged between $200 and $210, the investor could sell the option to recover some of the initial investment or call the stock. If just prior to expiry 3M was worth $205, the investor could sell the option for $5 per share, losing $500 on the contract, or call the stock — effectively paying $200 plus the option premium of $10 for a total cost of $210 per share. The call option owner doesn’t get dividends.
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Buying calls provides a lot of leverage but over time this strategy puts market math against the investor. While the S&P 500 moves up more than 12.5 per cent just over half the years, if an investor pays 12.5 per cent premiums for options with a year of time value and does an average job of selecting stocks, the strategy will lose during the other half of years where the market is up less than 12.5 per cent or down. On years the market is up a lot, however, it will pay off very well. My success buying calls has been spotty. I haven’t done it much because I don’t like the idea of paying more for a stock than its current value, and because it is a short-term focused strategy entering the realm of speculation.
Buying calls makes sense if you are expecting a lump sum payment soon, which you want to invest in the market. If valuations are attractive, you can start pre-buying with calls and locking in the future purchase price of the underlying stock.
Selling covered calls
If I owned 100 shares of 3M, I could sell this call for $10, which is referred to as “covered” because the shares are in the account to cover the potentiality of the option buyer exercising his or her right. This is an often-touted strategy to earn extra “income” on owning a stock. It provides a small amount of downside protection.
This is a valid strategy I use sparingly. It caps the upside of a stock to the strike price, plus premium, plus dividends. Contrary to the above, it puts market math in the investor’s favour, as option premiums are often in the one per cent per month range, similar to market growth rates. Option premiums can vary significantly, depend on the volatility of the stock, current market volatility as well as the difference between the current stock price and the strike price selected, and time to expiry. The greater the volatility the higher the premium.
Selling covered calls makes sense if numerous stocks owned look overvalued and selling would incur large taxable gains. An alternative is to sell calls to avoid the immediate tax, providing some income if valuations correct. If the stock is called a taxable event occurs, but if a number of covered calls were sold, it is unlikely all will be called.
Buying puts
While most of my option activity is around selling puts, clearly someone must be buying them. This is used as a downside hedging strategy. Once again, market math works against the buyer, but the seller accepts a higher level of risk. I don’t recall ever buying a put on an individual stock but have periodically bought market index puts when I was concerned about market direction. I purchased some just before the COVID-19 crash but sold them much too quickly. I’m just not oriented to short-term market trading strategies and find greater success with a long-term investing approach.
There are more complex option strategies. This covers the basics, but clearly an article of this length can’t cover all aspects. Selling options is generally more profitable as the math is in the seller’s favour. However, buying puts works during major bear markets and buying calls works in strong bull markets. In other words, buying options works when there are big price moves.
