Building From Basics: Options Investing 101

The basic types of options include calls, puts, covered calls, and protective puts. Call and put options do not require holding the underlying security (uncovered), while covered calls and protective puts entail owning the underlying security as well. Each has its own risks and potential rewards.

Options may afford investors a level of flexibility, granting them the right to buy or sell a security at a predetermined price (the strike price). Investors who buy a call or put option are not obligated to exercise it, though they pay a premium to purchase the option.

An investor who buys a call option on a security has the right to buy that specific security at the strike price by the option’s expiration date. An investor who buys a put option on a security has the right to sell that security at the strike price by the option’s expiration date.

Buying and exercising a call option in a rising market environment may allow an investor to harness a profit. Should the price of an underlying security rise above the strike price, an investor may exercise the call option to buy the security at the strike price. From there, the investor may choose to sell it at market price, generating a profit from the difference. However, the option premium must be considered when calculating net profit because investors pay premiums when buying an option. Call option purchasers may experience loss if they buy a call option, but it expires unused because the underlying security’s price failed to rise about the strike price.

Alternatively, buying a put option in a declining market environment means an investor could potentially purchase the security at a lower market price. They could then sell it for the higher put strike price, thereby making a net profit (minus the premium paid). However, investors who purchase a put that expires unused because the price of the underlying security failed to decline incur a loss of the premium paid.

Selling (writing) options generates a premium for the seller but comes with its own risks. Uncovered calls and puts may result in a loss for the option writer should the buyer exercise their option. If they do not already own the security, a call writer would need to purchase the security from the market at an elevated price in a rising environment if the purchaser exercises a call option with a strike price below the market price. This generates a loss, though the premium received from writing the call may dampen that loss.

In the case of a put writer, they would need to come up with enough cash to buy the put option at the strike price. If the writer does not have enough funding, they may be forced to sell out of other positions to fund the closure of the put option.

Covered calls and protective puts have their own risk factors to consider. Owning the underlying security as a covered call writer could result in the sale of a security below its market value. With no limit to how much a stock may appreciate over a given time, the opportunity loss could be significant. However, should prices decline or stay below the strike price and the option expires, the writer retains the underlying asset in addition to their premium earned.

Protective puts can work similar to an insurance policy on a security. The buyer may seek to hedge against potential losses for an asset they already own or purchase at the same time as the put. A protective put is intended to set a floor on the level of price depreciation the investor will experience on a security. Should the underlying asset’s price fall but fail to decline below the strike price and the put option expires, the buyer loses the premium paid as well as the realized losses on the underlying.

A growing number of funds use covered calls and protective puts in their strategies, seeking a variety of outcomes. Some strategies use puts to hedge against potential losses, while others write covered calls as an added source of potential income for the fund. Understanding the basics of options may allow an investor to understand the risks and opportunities better when investing in options and options strategies.

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This article is prepared as a general source of information and is not intended to provide legal, investment, accounting or tax advice, and should not be relied upon in that regard. If legal or investment advice or other professional assistance is needed, the services of a competent professional should be obtained. Information contained in this article does not constitute and shall not be deemed to constitute advice, an offer to sell/ purchase or as an invitation or solicitation to do so for any entity. The content of this article is based on sources believed to be reliable, but its accuracy cannot be guaranteed. BMO InvestorLine Inc. and its affiliates, sponsors and employees do not accept responsibility for the content and makes no representation as to the accuracy, completeness or reliability of the content and hereby disclaims any liability with regards to the same. Any strategies discussed, including examples using actual securities, quotes and price data, are strictly for illustrative and educational purposes only and are subject to change without notice. BMO InvestorLine Inc. is not responsible for the information provided and disclaims all liability with regards to the same.

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