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.
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?
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.