Buying Puts vs. Selling Calls. An Explanation for Rookies.

I received an e-mail question from a reader who is first learning about options.  His question is very basic, and I'm glad he asked the question.  It's important for everyone to understand the most basic concepts of options and how to use them.  For those of you who find this question too elementary, put yourself in his place.  If the answer to this question is not crystal clear, how can he understand how options work, and go on to use them successfully?  The most basic questions are the ones that must be asked.

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I am new to options trading and I am in the process of reading your book. But I had a question on the fundamental difference between buying a put and selling a call. As I understand it, essentially they are both declaring a downwards position on the stock. Why would you sell a call vs. buy a put? Is it simply because when you sell an option you get upfront money?

Thanks,
AP

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Hello AP,

The difference is huge. When you buy an option, you have rights. When you sell an option, you have obligations. That's why option sellers are paid – to accept those obligations. (corrected 9:38 am)

On an elementary basis, they are similar in that each represents a short position on the stock. Yes, each is a play that the stock will move lower. But that is where the similarity ends.

When you sell a call option, you do collect the premium (cash) up front. That's good. But if the stock heads higher, your losses are potentially unlimited. When, for example, you sell someone the right to buy stock @ $40 per share, the stock may move to 50 or 60 or 200. At some point you will be forced to buy back that option – and it's possible to have a gigantic loss.

When you buy a put option, you must pay cash. That's not a great thing to do, but in return for that cash, you have the right to force someone to buy the stock from you at the strike price. If the stock tumbles, you can make a lot of money.  Losses are limited to the cash paid for the option.

But, many times, the option buyer doesn't see the stock do what was expected and the cash paid to buy the option is lost. That's why buying options is so difficult. To profit, you must pick the correct direction for the stock. Not only that, but the stock price change must occur fairly quickly – before the option expires, or else the option becomes worthless – and the move must be large enough to offset the price paid for the option. All in all, a difficult thing to accomplish.

As an aside, selling a call option when naked – that means you do not already own enough stock to sell when the call option is exercised by its owner – is not allowed by many brokerage firms. They consider that strategy far too risky for option traders.

Especially rookies. I agree with that policy.

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22 Responses to Buying Puts vs. Selling Calls. An Explanation for Rookies.

  1. Rookie 10/07/2011 at 11:32 AM #

    So, when selling options, whether calls or puts, gains are limited to up front premiums?

    • Mark D Wolfinger 10/07/2011 at 11:57 AM #

      Correct

  2. Rookie 10/07/2011 at 12:47 PM #

    So..

    Selling a call = you are obligated to sell stock at strike price to buyer
    Buying a call = you have the exercisable right to buy stock from the seller at strike price
    Selling a put = you are obligated to buy stock at strike price from buyer
    Buying a put = you have the exercisable right to sell stock to the buyer at strike price

    Do you recommend that beginner traders stick to one over the other, buying v.s. selling options? It seems easier to me to make money off selling options for premiums where the risk is very low and consequently profit is also very low.

    Also: is volume a common problem in trading option contracts? It looks like it might be hard to dump a bunch of options even if in the money.

    • Mark D Wolfinger 10/07/2011 at 12:55 PM #

      Rookie,

      1) Clarification: When you sell a call, you are ONLY obligated to sell stock at the strike price IF THE OPTION OWNER ELECTS TO BUY THE STOCK. Many times options expire and become worthless.

      2) No. These strategies are so very different, that most traders will not want to adopt both. But there is no inherent reason why he/she could not do so. Yes, it is ‘easier’ to make money when selling options. The problem is that it is also possible to lose a LARGE SUM when selling options, and an occasional loss can wipe out years worth of profits.

      For that reason, I suggest selling call spreads instead of naked calls.
      I suggest selling put spreads, instead of naked puts.

      When you sell options and the RISK IS VERY LOW, the reward is also very small. That is NOT a good idea. Risk of loss is gigantic compared with profits, and only an occasional disaster can wipe out a trader.

      3) When you refer to a bunch of contracts, I assume you are referring to two or three THOUSAND contracts. Ten or twenty is not a bunch. It’s trivial.
      Some options have terrible market makers and you cannot get a good price fore your trades. That is not common. But it does happen so yes, volume is not to be ignored.

      • Rookie 10/07/2011 at 1:04 PM #

        Thank you. This clears up a lot.

        • Mark D Wolfinger 10/07/2011 at 1:16 PM #

          My pleasure

  3. Bill Adcox 12/18/2011 at 4:58 PM #

    Can you buy a put option for a strike price of $2.50 (for example) and then sell a call option for the same strike price? My question is will the put option automatically cancel out the call option if the call option is excersized? Basically I want to buy a put on RF on a strike price of $2.50 for May 2012 – 2 contracts will cost $38.00 plus brokerage fees. Then I want to sell the call options for January 2012 on RF for $1.41 per the same 2 contracts which will pay something like $290. My question is IF the call option is excercized and I’m called out at $2.50 will the Put option in place automatically excercize itself and ‘fill’ the Call order.

    Thanks.

    • Mark D Wolfinger 12/18/2011 at 7:12 PM #

      Bill,

      NO.

      First, when (if) you are assigned an exercise notice on the call options that you sold, you must sell 200 shares.

      Next, when you EXERCISE a put option that you own, you get to SELL shares. Thus, this is the direct opposite of what you need to do. You would have to BUY 200 shares to offset being assigned on the call options. Owning puts is of NO HELP because put ownership gives you the right to SELL shares. [Although you did not ask, if you had sold two put options, then the answer is still NO. The puts would not be automatically assigned to cancel your stock position. The put owner decides if and when to exercise. The seller cannot influence that decision]

      There’s another lesson here. If you were ‘called out’ on your two options, NOTHING is ever automatically done to help you with your situation. If you wanted to exercise any options that you own, you must make the decision and notify your broker. It will not be done for you. The ONLY time anything is done automatically occurs when expiration arrives. If you own any option that is IN THE MONEY, it will be excised automatically. Other than that, nothing is done automatically.

      If this remains confusing for you, please request more detail. The situation you describe is important, and you must be certain that you understand how it works.

  4. Bill Adcox 12/19/2011 at 2:47 PM #

    Thank you. That answers my question. I think I’m going to stick to writing covered calls.

    Thank you again for your time. I sincerely appreciate it.

    Sincerely,

    Bill Adcox

    • Mark D Wolfinger 12/19/2011 at 3:02 PM #

      CC okay for now.

      But at some point you will probably want to do something with less risk to a market collapse.

      Good trading

  5. Bill Adcox 12/23/2011 at 1:01 PM #

    May I ask a question about Bull Put Spreads? If I buy a Put deep in the money – in this case I’m referring to MSFT Jan options – if I buy the Jan strike price of $23.00 (currently 0.01) and sell the Jan Strike Price of 25 (currently at 0.02) – do they cancel one another out automatically if I’m called out? Basically I’m trying to figure out the mechanics of a Bull Put spread and if the bought put and sold put will cancel one another out automatically or if I’d have to go ahead and buy the stock to sell the stock (e.g. would I have to, at some point, potentially buy the stock or would the puts cancel out one another).

    Thank you for your time. I’m not sure where you’re located but I’d love to take you to lunch sometime if you’ve got time.

    I’ve done this with many authors – Tupper Saucy, Edward Griffing, Albert Dreisbach and numerous others so I can provide references from published authors that I’m not trying to do anything untoward.

    Thanks for your help. I sincerely appreciate it.

    By the way, what kind of trading strategy would you recommend for $1,000.00 starting position. I’m currently trading RF writing out of the money covered calls and making about 3 to 4% per month but I’d like to see if there’s a strategy that would (with managed risk) provice more like a 10% return if that’s possible and i wanted to see if you had any recommendations.

    Thank you again.

    Sincerely,

    Bill Adcox

    • Mark D Wolfinger 12/23/2011 at 2:01 PM #

      Bill,

      Good set of questions.
      Because I am no longer updating this blog, I’m going to borrow this question and use it on my premium blog ($37/month).

      I will send the reply to you as soon as I finish.

      Regards.

      $1,000 is really too little for doing much good stuff with options. IMHO, 10% per month is not possible for an extended time. Even 6% per month doubles an account in one year. Do you know people who routinely double their money every year? I don’t know any. If you can earn 3-4% on a consistent basis, and if you can gradually add cash to your account – you will be in fine shape. Right now, concentrate on your education.

      I live in Evanston, just north of Chicago.

  6. Bill Adcox 12/23/2011 at 5:15 PM #

    Would $10,000 give me access to ‘the good stuff’? Right now I’m just testing the waters with the $1,000 before I jump in with more and I’ll likely subscribe to your premium blog.

    Thank you for taking the time to work with me. I really appreciate it and I’m glad to know that I’m asking good questions.

    What books do you recommend going forward? Right now I’m reading Guy Cohen’s books and I’d like to expand my education.

    Do you think that 5% per month is too lofty a goal?

    Thanks again. I sincerely appreciate it and I’ll see if I can arrange a time for me to be near you for that lunch.

    Thanks.

    Bill Adcox

    • Mark D Wolfinger 12/25/2011 at 8:37 AM #

      Bill,

      Yes, with 10k you can do more. Of course, position size would still have to be small – but you would have a choice of option strategies.

      Obviously I recommend: The Rookies Guide to Options. It’s an excellent beginner book with additional material that makes it valuable as you gain experience.

      Also, McMillan: Options as a Strategic Investment is a classic. Take a look for it at your library and then decide if you want to own a copy. There’s another book that I like, but it is too advanced for you right now. Please do not rush out to buy it at this time. Natenberg: Option Volatility

      Yes, 5% per month is too ambitious. Traders can make that much, and you will make that and more in some months. But I’m sure you recognize how much that is in real world terms. You cannot make that much on a consistent basis without some real risk. Others will tell you differently, but let’s be reasonable: If these returns were available, the whole world would be playing this game.

      Lunch not necessary. Thanks. I’m glad to help.

      Other response delayed due to holidays.

  7. Bill Adcox 12/26/2011 at 1:38 PM #

    Thank you for your generosity of time and wisdom. i truly appreciate it and I hope you and yours have a happy merry Christmas and wonderful new year.

    i’d like to at least send you a thank you card with a gift certificate for a free meal in it (I insist). i fully understand that you would be hesitant to openly post or send your personal address so do you have a Po Box or somewhere similarly anonymous that I can send you an expression of my appreciation. Again, i insist so please let me do this for you.

    I’ve been trading RF writing covered calls one tick OTM and making about 3% per month now for several months. I’m planning on buying the LEAPS on EL for a strike price of $80 and a purchase (call option) price of $3880.00. They’re currently trading around $113 per share and we’re headed into a 2:1 stock split so I’m planning on selling the option (which will be deep in the money at the time of the split) fairly quickly.

    I’m subscribing to your premium blog as well. I sincerely appreciate your time and i’ve already purchased your book (did you know that it was not available on kindle?).

    Thank you again.

    Bill Adcox

    • Mark D Wolfinger 12/26/2011 at 2:19 PM #

      Hi Bill,

      My pleasure to be of help.

      1) Address is posted on my other web site. http://www.mdwoptions.com/Premium/guarantee/
      The credit card processor (Authorize.net) requires that it be posted. I eat inexpensive lunches.

      2) Buying LEAPS instead of stock has some advantages. But please be aware of the difficulties that can arise.
      You are planning to sell options that will be DITM after the split? For that to happen, the option has to DITM right now – unless you anticipate a huge rally.

      I have a feeling that you are missing something here. Which call are you planning to write again your long LEAPS position?

      3) Looking forward to having you as a Member.

      Yes. I know that my book is not available in a kindle version. That’s up to the publisher. In fact, they never told me that they now publish a paperback and e=book version. They just did it and it came as a surprise to me.

  8. Bill Adcox 12/27/2011 at 10:35 AM #

    I’m planning on buying the $80 strike price (delta of 85) for $38.80 (time 100). The price of the stock is currently 113.43 so I’ll be deep in the money and i’m buying the Jan 2013 LEAP. When it splits, I’ll be at $40 (hopefully still deep In the money).

    I’m planning on selling the day of the split. All the analysts’ have rated it as a strong buy and it has a lot of upward momentum (I think). The percent to double movement (at least as I’ve calculated it) is 51% so i’m certainly not planning on doubling my money. When it splits, I’ll have 2 contracts with a strike price of $40 at a break even price of $19.40. I think the stock will move 2 to 3 points on the day of the split so I’m going to try to pick up a couple of points on the options.

    That said, I may actually sell the option before the split – I’m not going to try to make a huge score here – I’m going to try to make just a bit more than 3% or so.

    Thanks for your help and assistance. Do you have an Outback Steakhouse near you and do you like them?

    My sincerest thanks. By the way, what do you think of my RF strategy of 3% per month. I think 3% per month regularly is fairly good. not sure it will work forever but it’s been steady so far.

    Thanks again.

    Bill Adcox

    • Mark D Wolfinger 12/27/2011 at 12:08 PM #

      Bill,

      I am essentially vegetarian.

      I don’t know why you believe the stock price will rise on the day of the split, but I never know when stocks will rise or fall. So if you expect that to happen, you will make some money.

      On the other side, if you sell your covered calls sooner,rather than later, you will have less risk – if the stock declines. Even god stocks go down when the whole market falls.

      I know nothing of RF. It appears to be a low-priced stock that has undergone some decent-sized price changes. 3% is good, as long as that is your profit after deducting trade expenses (commissions).

  9. Bill Adcox 12/27/2011 at 11:20 AM #

    Change of plans. I’m buying EL Leaps for Jan 2013 at $70 strike price with a delta of .91. The percent to double is 42%. I’m paying $44.40 per share for the strike price.

    My goal is to be Deep In the Money ($35 per share) when the stock splits. If the stock splits today, the price would be $56.79 which would put me $21.79 in the money. Again with a delta of .91 that would put the options price (if I’m correct in my calculations) at around $19.83 (my breakeven price is $22.00). The stock would have to move approximately 5 to 6% for me to make money. I’m thinking that this is a fairly realistic expectation going into a split. But I think my risk is managed by being Deep in the Money and having a LEAP (basically I don’t think that I can lose much if I end up loosing).

    Thats the plan. Any advice or suggestions would be met with joy and appreciation.

    And I do again sincerely appreciate your advice, widsom, time and talent. I want you to know that I am a High Functioning Autistic Adult who has been told that he is disabled, can’t work and isn’t fit for anything in society. Trading has given me a purpose in life and a fulfillment I cannot fully explain. I want you to know that your input is deeply, deeply appreciated on a fundamentally deep and profound level.

    My goal is 1 to 2% per month in trading and i’ve acheived that goal consistently for more than 2 years now. However, i’ve never had anyone guide or coach me. I’m definitely not a ‘get rich quick’ person. I’m a ‘slow and steady’ plan making individual.

    The bottom line is that your willingness to help me means more to me that I will ever be able to express. Please know that I will never take advantage of the privelige of communicating with you and that you have made a powerful, positive impact on my life and for that I will be forever greatful.

    I fully intend to take you out to lunch sometime in the future. in the meantime, i hope that I can continue to communicate with you in a respectful, appreciative way.

    I’m a licensed contractor with years of experience in dealing with insurance claims on Real Estate so if there’s ever anything i can do to help you please don’t hesitate to ask.

    Again I want to sincerely thank you for everything. I will never be able to tell you how much it means to me that you’re taking your valuable time on me. you mean a lot to me. Thank you.

    Sincerely,

    Bill Adcox

    • Mark D Wolfinger 12/27/2011 at 12:19 PM #

      Bill,

      I urge you to ignore ‘% to double.’ Writers of covered calls do not have an opportunity to each such large profits.

      If the option is $44.40 now, it would be (all other things being equal) $22.20 if the stock were to split 2-for-1 right now. I do not know where you came up with $19.83, but it is not correct. If he stock splits, there is no reason for the options to lose value. There is no reason for you t need a 5% move just to break even. I hope that you understand the logic. When a stock splits, no one gains or loses money – unless the stock price changes.

      I must correct another thought of yours. You own a LEAPS option with a 91 delta. If this stock falls in price by any significant amount, you will lose money. The fact that you own a LEAPS option does not mean that you have little risk. You can lose a fair amount of money on this deal. It may be very unlikely, but it is possible.

      You do not mention which calls you plan to write. That is important and I’m interested in your thoughts.

      Thanks Bill. I am here to help.

  10. Liam 04/06/2013 at 2:03 AM #

    Hi, so I am also new to options which is why I’m here. I just had an idea about profiting from options that I haven’t heard anyone talk about yet, and I wonder if it is a legitimate way to make money as an option strategy…

    My understanding is that options in themselves have a market value price which is influenced by some interaction between time until expiration (time decay), the size of the spread between the price of the security at a given time and the strike price specified, and IV/RV (volatility).

    Could someone simply trade options by buying ones they believed were going to appreciate in the short term and then resell them to the market if they were dated for expiration far enough into the future, treating them like stock, but with rights/ obligations? What would be wrong with doing something like this? Please let me know if something I said doesn’t make sense, thanks.

    Yes, it makes sense – as far as it goes. And many, many people claim they do exactly as you suggest. However, it is next-to-impossible to make this work. However (see end of reply), there is a specific situation that you may be able to make work.

    Options are not stocks and they do not trade like stocks. That means it takes more than the price of the stock to move higher for the call options (the ones you bought) to move higher. In fact, it may surprise you to know that there are plenty of situations in which a stock may rally from 60 to 61 where the call options decline in price. Other factors also affect option prices – the most important of which is the volatility – specifically: How volatile will this stock be from this point in time until the options expire. Trust me, this factor often is stronger that the stock price in determining the option price. Not always. But often enough to kill your plans.

    The reply is more complicated that this short reply – but what you want to do cannot be done by you (or me).

    The exception. If you are VERY skilled at predicting stock direction. If you have a proven track record of making the winning stock pick. If you are not lying to yourself about that track record, then maybe, maybe you can buy 80-delta options and treat them the same as stock. There are are many drawbacks – the largest of which is that many options have wide bid/ask spreads. If you are not experienced enough of a trader to understand ‘slippage’, be sure to get a solid understanding of just how expensive that can be to an options trader.

    I wish you well. But what you seek to do takes a good deal of practice – plus the rare ability to correctly predict stock direction, plus a knowledge of how options work. I can teach you the latter, but not how to predict direction

  11. kanis 08/02/2014 at 8:58 PM #

    Hi Mark
    Very informative site.
    Just getting into options, not trading yet. have been trading stocks for a few years.
    Going back to the beginning of this page, what is your opinion regarding buying a futures contract and selling a call option (both with same expiry month) in terms of downside risk? I understand the upside profit cap.

    regards

    Kanis

    Kanis,

    . You can buy one single stock futures (SSF) contract and write one call option. I do not see any rationale for making this trade.

    It is true that buying stock futures comes with a much smaller margin requirement than buying stock – so that it is possible for you can gain extra leverage on your money with the suggested strategy. However, I see two problems with that:

    a) Extra leverage is just another way of saying “extra risk” and there is no good reason for anyone – especially a newer trader – to accept extra risk.

    b) I do not know about the margin requirement for selling the call option. Although owning the futures contract should allow the call to be sold as “covered” the option rules may demand that the option be considered “naked.” Although the position is “covered” as far as risk is concerned, it may be uncovered as far as margin requirements are concerned — and that would destroy any leverage advantages.

    One more point. I did a quick Google search for SSF and although several sites talk about expiration dates, the only mention I can find is that they occur “monthly” and quarterly. Thus, I do not know whether they expire after the 3rd Friday as do standard stock options. If the dates differ, that would present a risk when one contract expires before the other.