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Buying vs. Selling Options

Montréal Exchange
February 28, 2022
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14 minutes read
Buying vs. Selling Options

Learning how to trade options requires a strong fundamental understanding of the 4 core options strategies. These strategies, buying and selling of Call and Put options are the foundations for both simple and complex trading strategies. We’ve created this guide to help users understand the nuances of these strategies and how they should be applied in bullish, bearish and even neutral outlooks of an underlying stock, ETF or currency. Many beginners trade options without understanding how the price of a call or put option needs to be factored into the decision-making process. In this piece, we explore examples that use BMO stock from Friday March 27th, 2020 to analyze various outlooks using call and put prices. Please view our recently recorded webinar on Buying vs. Selling Options to learn more.

 

Introduction – Understanding Stocks vs. Options

Stock trading allows traders to speculate on the directional movement of a stock. When compared to trading options, trading stocks is simple but limited. Entering a stock position gives the investor exposure in either direction, providing dollar for dollar, linear exposure. On the other hand, stock options are far more flexible but add complexity. Options allow for exposure in direction, magnitude, and timing unlike stocks that only allow for exposure on a specific direction:

  • Direction – Buying or Selling a Call or a Put
  • Magnitude – Options allow traders to gain exposure on how much a stock will move by selecting different strike prices
  • Timing – Selection of expiration dates allow different time frames for the outlook to occur

Due to this increased complexity it’s important to understand the nuances of the directional views with options before learning to select specific expiration dates and strike prices.

 

Calls and Puts

There are 2 types of options – a call option and a put option. A call option gives the buyer of the option the right but not the obligation to buy the stock at a specific price (strike price) on or before the expiry date of the option in case the option is of American type. A put option gives the buyer of the option the right but not the obligation to sell stock at a specific price on or before the expiration date in case the option is of American type. Each contract represents 100 shares of the stock. Before buying or selling options, there are a few terms that one should know:

  • Current price – the last traded price of the stock
  • Strike price – the price at which the holder of an option can buy (call) or sell (put) the underlying stock
  • Expiration date – the date at which the contract expires

When trading options a trader can take 4 actions:

 

Bullish Strategies

  1. Buying a call option (bullish by ‘a certain amount’) – Call options are typically considered for a moderate or strong bullish view on the underlying stock. For example – BMO stock is currently trading at $66 per share on March 27, 2020. If an investor expects this stock to rise, he can buy a $66 April call option for a $5 premium (per share). This gives the right, but not the obligation to buy the stock at $66 per share. If the investor is correct and BMO rises, the investor can sell the call option for a profit or exercise the option to buy the shares at $66 and sell them at the higher market price to profit from the difference. However, the premium paid to enter the contract needs to also be accounted for. Therefore, the actual profit is the difference between the strike price and the market price, minus the $5 paid upfront. Due to this, it is important to clarify that buying a call option is specifically being bullish by ‘a certain amount’. That amount is linked to the premium paid for the call option. A call option’s breakeven price is the strike price + the cost of the call option. Only if the investor believes that BMO will break above its breakeven price, of $66 + $5 = $71 would the call option be a worthwhile investment. Otherwise, even with a bullish view, the call option would provide a partial or total loss if BMO is below $71 at expiration.
  2. Selling a put option (bullish, but not too bullish) – Selling a put option is typically considered a bullish strategy on the underlying stock. For example – BMO is currently trading at $66 on March 27, 2020. If an investor expects the price to remain neutral or move higher and sells a $66 April put option for $5 premium (per share). The seller will immediately receive $5 per share and will have the obligation to buy the shares from the buyer of the put for $66 if the contract is exercised. If the investor was correct and BMO remains at $66 or higher, the put option will expire worthless and a $5 profit is booked. Additionally, selling put options can allow the investor to be profitable even if the stock moves in the opposite direction, only suffering losses when the stock makes a move lower than the $5 premium received. However, it’s important to make the distinction that if BMO were to move significantly higher, the put seller will still only profit $5. Due to this, we want to clarify that selling a put option is useful when the investor has a bullish view, but not too bullish. Since an investor with a very bullish outlook would find it far more advantageous to buy a call instead of selling a put.

Bearish Strategies

  1. Buying a put option (bearish by ‘a certain amount’) – Put options are typically considered for a moderate or strong bearish view on the underlying stock. For example – BMO stock is currently trading at $66 per share on March 27, 2020. If an investor expects this stock to fall and buys a $66 April put option for a $5 premium (per share). This gives the right, but not the obligation to sell the stock at $66 per share. If the investor was correct and BMO falls, the investor can sell the put option for a profit or buy the stock at the lower market price and exercise the option at $66 to sell at a higher price. However, the premium paid to enter the contract needs to also be accounted for. Therefore, the actual profit is the difference between the strike price and the market price, minus the $5 paid upfront. Due to this, it is important to clarify that buying a put option is actually being bearish by ‘a certain amount’. That amount is based on the premium paid for the put option. A put option’s breakeven price is the strike price – the cost of the put option. Only if the investor believes that BMO will break below its breakeven price, of $66 – $5 = $61 would the put option be a worthwhile investment. Otherwise, even with a bearish view, the put option would provide a loss if BMO stock is above $61 at expiration.
  2. Selling a call option (bearish, but not too bearish) – Selling a call option is typically considered a bearish strategy on the underlying stock. For example – BMO is currently trading at $66 on March 27, 2020. If an investor expects the price to remain neutral or move lower and sells a $66 April call option for $5 premium (per share). The seller will immediately receive $5 per share and will have the obligation to sell the shares to the buyer of the call for $66 if the contract is exercised. If the investor was correct and BMO remains at $66 or lower, the call option will expire worthless and a $5 profit is booked. Additionally, selling call options can allow the investor to be profitable even if the stock moves in the opposite direction as this strategy only suffers losses when the stock makes a move higher than the $5 premium received. However, it’s important to make the distinction that if BMO were to move significantly lower, the call seller will still only profit $5. Due to this, we want to clarify that selling a call option is useful when the investor has a slightly bearish view, but not too bearish. Since an investor with a very bearish outlook would find it far more advantageous to buy a put instead of selling a call.

 

 

Summary

Trading options come with additional complexity but adds flexibility compared to trading stocks as investors can speculate on direction, magnitude and timing. The flexibility of options also allows investors to use them for either income generation (selling calls and puts) or leverage (buying calls and puts). Before entering an options position, investors should understand the nuances of the various bullish and bearish strategies and how they should be utilized. More importantly, the pricing of the call and put options is the most important factor in the magnitude of the outlook before deciding whether an option strategy makes sense. The $5 paid or received for the BMO call and put options in our examples are critical to determining how bullish or bearish an outlook needs to be in order to be profitable on an options trade.

Take advantage of free access to OptionsPlay Canada: www.optionsplay.com/tmx

 

Disclaimer:

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

Copyright © 2022 Bourse de Montréal Inc. All rights reserved.  Do not copy, distribute, sell or modify this document without Bourse de Montréal Inc.’s prior written consent. This information is provided for information purposes only.  The views, opinions and advice provided in this article reflect those of the individual author.  Neither TMX Group Limited nor any of its affiliated companies guarantees the completeness of the information contained in this publication, and we are not responsible for any errors or omissions in or your use of, or reliance on, the information. This publication is not intended to provide legal, accounting, tax, investment, financial, or other advice and should not be relied upon for such advice. The information provided is not an invitation to purchase securities listed on Montreal Exchange, Toronto Stock Exchange, and/or TSX Venture Exchange. TMX Group and its affiliated companies do not endorse or recommend any securities referenced in this publication.  Montréal Exchange and MX  are the trademarks of Bourse de Montréal Inc.  TMX, the TMX design, The Future is Yours to See., and Voir le futur. Réaliser l’avenir. are the trademarks of TSX Inc. and are used under license.

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