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2.2 Basics: Call vs. Put

As you've already noticed, there are only two types of option contracts - calls and puts - and all you have to be able to do, in a nutshell, is deal with them. Let's go a little deeper into the matter. But for this moment let's limit ourselves to long calls and long puts.

The long call option is the basic trading strategy where you buy a call option with the expectation that the price of the stock will rise well above the strike price before the expiration date. This means that the more the price rises from your chosen strike, the more the option will be worth in the end. However, you must first select this strike price. You can choose a call option that is either "on or in the money". If you can't wait what this means, please turn to the chapter "Moneyness". An option at the money, i.e. at the current price, will rise in value earlier than an option further out (in this case above the current price). But the former is much more expensive. Let's say a stock is currently quoted at 30 USD and you have chosen a strike of 40 USD, i.e. a strike "outside the money", because you are very optimistic about the future of the stock.

Now, of course, your expectation is that the stock price will at some point in the future be well above the 40s price before it declines. If the stock price is about 30 USD at the moment, you hope that the price will rise above 40 USD over time, because this is your "starting point". Only when the price exceeds USD 40 you start earning money. This is primarily due to the intrinsic and extrinsic value, which we will discuss in detail later. Compared to the direct purchase of shares, the buyer of a call option uses the leverage effect mentioned above, as one contract moves 100 shares at a time.

The maximum loss on call options is limited to the amount of the premium you paid for them. What exactly does that mean? It can happen that you still hold the call option and the stock is below your strike on the expiration date. The option would then expire worthless and the loss would be the price paid for the call option. In our example here we assume that you had to pay 2 USD for this option contract. According to the conversion you already know, you would have paid 200 USD, which is your maximum loss.

Also the positive case is logical and easy to understand. If you assume that the stock will be far above the exercise price of 40 USD, this would be a good thing for you. Let's say the stock is 50 USD on the expiration date. You now have the right to exercise your option and would immediately collect the 10 USD difference. By the multiplier we speak of 1,000 USD.

But what happens if the stock were quoted at 30 USD? We have already said that you would have to accept a loss of 200 USD. Remember the example of the cheeseburger voucher. The stock is now quoted lower than you thought. Why should you buy it now, when your voucher is 40 USD and you could buy it cheaper directly from the market? In this case your option has expired worthless.

I think here again some of the benefits of the reduced risk features of option trading come into play, because now you would be happy to lose only the 200 USD instead of the loss you would have incurred if you bought 100 shares at 40 USD and they were now worth only 30 USD. A comprehensible calculation - isn't it?

So you have a loss limit. But is there also an upper limit? With long call options, the profit potential is theoretically unlimited, since the best thing that can happen is that the stock price goes "to infinity". This, of course, is a purely fictitious consideration and will not happen. What is important is that you know that in principle there is no upward limit.

How is the price influenced at all over the course of time? Now that implied volatility increases over time, which we will talk about very carefully later, it has a positive effect on the strategy if all other factors remain the same. So an assumption ceteris paribus. This tends to increase the overall value of the long options, as the exercise price is more likely to be exceeded by the expiration date. An increasing volatility would play into your cards in this case.

Can volatility also play against me? It can do that unconditionally. If the option or stock is currently trading at 40 USD per share and the market is not volatile, which means that the stock is not really moving, so maybe a few cents down, a few cents up, then the value of this option contract drops because the chance is no longer that great that the stock fluctuates into a potential profit zone. Before criticism is levelled here, this is a simple, bold example. Volatility is by far not the only factor that affects option prices, but at this point we're just trying to put a foot in the water for the first time. All the factors are still discussed in detail later.

Over time, this has a negative impact on the strategy. This applies to all long options (long call and long put). These should not be confused with the term "being long" in equities, because options only have a limited life. As time passes, the value or time the stock needs to move into a favorable zone becomes less and less. This is called a time value (theta). This decreases every day. As soon as the time value disappears, only the intrinsic value remains - i.e. the difference between the exercise price and the current market price.

Any more that might affect my option? Yes, that's right. In addition to the fluctuation intensity, time also plays a decisive role. At this point, however, you don't need to be afraid of being overtaxed. I will explain all these terms to you in detail and you will find that the whole thing is really not difficult. Again, options are not witchcraft.

All right, let's turn things around and look at the put options. The long put option is the second option trading strategy we want to look at, where you buy a put option with the expectation that the stock price will fall well below the strike price before the option expires. If you have already gained experience in the world of stocks, the term long put will certainly confuse you. Forget for a second what you have used so far as an interpretation and get involved in the following value-neutral. Compared to short selling, you now have the opportunity to build up a bearish position in your portfolio with limited risk by using a long put option.

With a put option, you enter into an agreement with another person that states that you will sell shares at 40 USD per share in the future. This is your strike price. Let's do the whole thing again with a striking example. Imagine building a house for someone. If you agree to build the house for 100,000 USD for the contractors, they agree to pay 100,000 USD for this house when it is finished. You now conclude a put contract as a house builder.

Now it is your goal and task to build this house for less than 100,000 USD - materials, labor, permits, everything - you want to spend less money, buy the material cheaper and just hire the people to build the house for less than the agreed price that has already been agreed. So if you manage to finish the house for 80,000 USD for example, you still sell it for the agreed 100,000 USD, the difference is therefore your profit. I'm sure this example sounds logical, but if you can't quite convert it to put contracts yet, then that's no big deal. We will often come into contact with this principle, so that you don't have to understand everything at the first attempt.

So, again, just this time without houses. You sell a stock at a certain price in the future and hope that you can buy the stock at a lower price in the future. This means that the value of the stock decreases and therefore your profit increases incrementally. So a classic short sale.

Let's give another example with numbers. Let's say that a stock is quoted at 50 USD and we want to buy a put "out of the money". Let's take the strike at 40 USD (the more bearish you are, the further down you would go). This means that if the underlying falls below 40 USD, we are in the profitable zone. As with long call options, you also have an integrated loss limit. Your loss only amounts to the premium paid, which was fixed at the beginning of the contract. For example, 200 USD.

However, unlike the example with our house building project, you are not obliged to buy the stock if it exceeds 40 USD. Remember, as an option buyer, you own rights, not obligations. There is no reason for you to buy the stock at 50 USD if you have speculated on falling prices.

Here, too, increased volatility has a positive effect on the strategy, just as we have seen with long call options. If the volatility increases and the market is more volatile, which means that the price could range from 40 to 30, up to 50 and back to 30, there is a greater chance that the option will continue to be profitable. Volatility, the vega, makes the option price more expensive when it rises - exactly what you want.

Well, as with call options, time (theta) also affects a long put option. With long options, both put and call, the decline in theta has a negative effect on the option price. We remember that options are finite. They have a final date on which they expire. So as time goes by, the value of those options goes down because the stocks have less time to get into the potential profit zone. So as option buyers, we always play against time, which can be very negative, especially in combination with low volatility.

Before we close this chapter, we need to look again at the breakeven of long puts, the point at which you start to be profitable. Let's stick to the above example where you bought a long put at a strike of 40 USD for 2 USD premium. Your break even is reached at 40 USD – 2 USD = 38 USD. The further the stock falls below this price, the more you will earn. However, the theoretical profit potential is limited here, as a stock could in principle also fall to 0. On the other hand, your biggest possible loss is 200 USD.

Remember:

For options, you have the choice of a strike price, you are not tied to the share price.

With long calls/puts you pay a premium that is your maximum loss at the same time, your profit is (theoretically) unlimited

Options are influenced by various factors (the "Greeks").