Calls and puts: the only four scenarios there are

The rules of the map

Before going through the squares, the two rules that order everything else. They already came up in parts 1 and 2, but they deserve to stick, because from these two sentences you can derive the rest of the article:

• A call is the right to buy at an agreed price. A put, the right to sell at an agreed price. Call buys, put sells — that short.
• Whoever buys the contract pays the premium and decides. Whoever sells it collects the premium and is obligated to deliver if the other side exercises. Money and freedom travel in opposite directions.

We stay with the same company as the previous parts: Verizon trading at $47 and contracts of 100 shares. The call we are going to use is literally the one from parts 1 and 2 — strike $50, premium $2 per share — so those numbers will already sound familiar. The put is the new piece: strike $45, premium $1. Every premium that crosses here is a real $200 or $100.

The two sides of the call

You buy a call (strike 50): you pay for the rise

This is the trade we took apart fully in the first two parts, so here is the summary with its math. You pay $200 today for the right to buy at $50. If Verizon does not reach 50, your right dies worthless. If it gets there but falls short, you recover crumbs. To really win you need it to get past:

That number — strike plus premium — is the breakeven point, and it is the same $52 from the three-zone chart in part 2. Buying a call is not betting that it goes up: it is betting that it goes up more than what you have already paid.

You sell a call (strike 50) while owning the shares: you get paid for the ceiling

Now turn around and look at the same contract from the other side. You own 100 Verizon shares and you sell someone else the right to buy them from you at $50. You collect $200 today — real money, in your account this afternoon. What can happen? If Verizon does not reach 50, you keep the premium and the shares, and you can repeat the play next month. If it goes past 50, you hand over the shares at the agreed price; with the $2 of premium you already collected, it is as if you had sold them at 52.

Notice the change in temperament: the buyer needs something to happen; the seller gets paid for nothing happening. It is the same trade and two opposite ways of being in the market.

The two sides of the put

You buy a put (strike 45): you pay for insurance

The put reverses the direction of the right: now you pay to be able to sell at an agreed price. When would you want that? For two different reasons. The usual one, and the one this series uses: you own Verizon shares and a drop worries you. The other: you don’t own them and you are betting it falls — that is why the table further down, which measures the contract on its own, says it goes well for you if Verizon drops below 44. For $100 you buy the right to sell them at $45 no matter what: if Verizon sinks to 30, you still sell at 45. It is, literally, car insurance — you pay the policy hoping never to use it, and if the year ends without scares, that $100 was the price of sleeping soundly.

You sell a put (strike 45): you get paid to commit to buying

And we reach the most interesting square of the four — the one fewest people understand and the one we will use most in this series. You sell a put and collect $100 today. In exchange for what? For committing to buy Verizon at $45 if its owner decides to sell it to you, which they will only do if the stock falls below that.

Put that way it sounds like a trap: you collect pocket change for risking buying something that is falling. But turn it around. What if $45 is a price at which you already wanted to buy Verizon anyway? Then the deal shows a different face: if the stock never falls that far, you get paid $100 for waiting; if it falls and you get assigned, you buy the stock you wanted, at the price you wanted, and at a discount on top:

That discount of the premium on the purchase price is the core calculation of half the series — and of the guide on cost basis after an assignment, when it is time to do it with several premiums piled up.

The complete map, in one table

And now, the symmetry almost nobody talks about. Look at the numbers again, contract by contract. In the call, the buyer needs Verizon to get past 52 and the covered seller delivers at an effective 52. In the put, the buyer starts making money below 44 and the seller buys at an effective 44. It is exactly the same number, seen from opposite sides of the counter. What one side pays to be able to decide is, cent for cent, what the other collects for waiting.

Read it twice if you need to: when this symmetry clicks, options stop looking like a trick and start looking like what they are — a market where time is bought and sold.

And which of the four is for you?

Honestly: the two in the bottom row, the ones that collect. Buying options requires getting three things right at once — the direction, the size of the move and the timing — and part 2 already showed how expensive it is to get only the direction right: Verizon rose 4% and the buyer lost everything. Selling, on the other hand — a cash-secured put, a call backed by shares — gets paid for waiting for prices at which you wanted to trade anyway. It is slower. It is frankly more boring. And it is much easier to sustain month after month, which is the only thing that matters in the long run.

Next stop: you have spent three articles looking at $200 and $100 premiums as if they were clean figures, and they are not. What exactly you collect when you collect a premium — with its commissions, its calendar and the commitment that rides along as a stowaway — is part 4.

Keep reading

• What happens when an option expiresThree outcomes, not two. Exercise, assignment and expiration, with the buyer’s and the seller’s numbers side by side.