Trading calls & puts

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Single option strategies: the four horsemen

Stocks are a two-way street—up and down, that’s it. With the exception of a stock that pays a dividend, there’s no other way to make (or lose) money.

But options? That’s a different story. Not only can you trade options on stocks moving up and down, but sideways, too. You can even trade time and volatility regardless of a stock’s direction, as long as it doesn’t really move.

But before you learn complex strategies that capitalize on Mercury in retrograde (don’t worry, we’ll leave astrology out of this article), there are four basic option strategies that serve as the primary tools in the option-trading toolbox. Many refer to these as “single” option strategies, because they only require one option. They are:

  1. Long call
  2. Long put
  3. Covered call
  4. Cash-secured puts

Long calls and puts are the most basic of all the options strategies, and perhaps the easiest to execute because, well, they’re generally a lot cheaper than the stocks they’re attached to (and simpler to understand). Like stocks, you buy a call or put based on your opinion of the stock’s trend, and then sell them at some point, hopefully for a profit. (Remember, buy low, sell high.)

Simple right? Well, there’s more to it. Not only do you have to be right on direction, but you have to guess correctly on time and volatility, too—which could work against you even if the stock behaves exactly as you want it to. Another way to think about this is when you buy a stock, you only have to be right about it’s direction (i.e., that it’s going up). But with options, the degree of difficulty is a bit higher because you must correctly guess the:

  • direction of the stock
  • how far it will go
  • when it will get there

Before you jump into buying a call, remember that someone is going to take the other side of your trade for all the opposite reasons you’re taking yours. Only one of you will be right so in many ways, the difference here comes down to your personal interpretation of information at hand. If you think that time and volatility are working against you on a long option position, it stands to reason that time and volatility are working in their favor because they sold it.

For many, single option buy strategies may be just fine, but are they right for you? That’s for you to decide. But first, it’s worth learning as much as you can about as many strategies as you can so that you recognize the role that options could play in your trading (beyond just up and down).

So, let’s take a look under the hood of the two single-option buy strategies—the long call and long put.

NAME: LONG CALL

PROFIT GRAPH:

WHY TRADE IT? You think the stock is going up within a certain time frame.

OPTIMAL CONDITIONS: Low volatility, bullish stock, sector, market

SETUP: Buy a call. That’s it.

EXAMPLE: Buy Aug 100 Call for $3

COST: What you spent on the call (In this example, $3 x100 = $300 total). This is called the “premium”.

THEORETICAL MAX PROFIT: The sky’s the limit. (Although it’s not likely the stock will go up to infinity, long calls have unlimited profit potential because the stock can go up forever.)

THEORETICAL MAX LOSS: The price you paid for the call (In this example, $3)

BREAKEVEN AT EXPIRATION: There’s one breakeven point at the strike plus the price you paid for the call (100 +$3 = $103 breakeven)

BEST CASE TO NAIL IT: The stock moves higher right away, resulting in a profit. Though a simultaneous rise in implied volatility could help inflate the call premium, too, it’s not as common with options on rising stocks.

WHAT CAN GO WRONG? Your stock doesn’t rise quickly enough or is below the breakeven point as expiration nears.

The rate of time decay or a drop in volatility could exceed the benefit of any stock price appreciation. This is why many options traders seek out long calls that have low historical volatility and longer expirations.

CLOSING THE TRADE: If the trade is profitable, you can close it prior to expiration. Remember, try to keep things simple here. Buy low, sell high. Don’t forget, even if you get a big move early in the life of the trade, time will begin to decay the value of the long call the closer you get to expiration. A good trader knows when to stay in a trade, but also when to get out. Sometimes, it can be better not to be greedy and “ring the register” (meaning, take profits).

Of course, the stock might not go high enough to be profitable at expiration, it might stay where it’s at, or go down. In these cases, the long call will lose value. You can either cut your losses and sell the option for less than you bought it prior to expiration, or take the max theoretical loss and let the option expire worthless. In this case, the option will automatically be removed from your account after expiration.

If you want to exercise the long call and buy shares of the stock, that’s up to you—it’s your right under the contract. This is typically only done if the long call is in the money. At this point, you’re willing to take on the risk of owning 100 shares of the stock and have the money to buy the stock. In our example, the August 100 call, you’d need $10,000 to buy 100 shares. This is why most options traders simply close the position by selling the option back into the market. And remember, at this point, the theoretical max loss (the cost of the call option) no longer holds true. Once you own 100 shares of stock, your risk is the price you paid for the stock all the way down to 0. In our example, that would be $100 + $3 (the cost of the call), for a total risk of $10,300.

KEEP AN EYE OUT FOR… Your call will “auto-exercise” without your say-so if it’s in the money by just $0.01 or more, if you hold it to expiration, and you have the available assets to exercise. When you exercise a call, you’re on the hook to purchase 100 shares of the stock at the strike price. Some brokers will automatically close your call option prior to expiration if you do not have the money to buy the stock. It’s important to read and understand your specific broker’s options agreement to know if that is the case. But DON’T depend on this—always keep an eye on your positions, particularly the week of expiration. A broker will simply look to get you out of the position, but not necessarily care when, or at what price. It’s best that YOU manage your trade prior to expiration. Nobody will care more about your position than you!

NAME: LONG PUT

PROFIT GRAPH:

WHY TRADE IT? You think the stock is going down within a certain time frame.

OPTIMAL CONDITIONS: Low volatility, bearish stock, sector, and market

SETUP: Buy a put. Nothing more to see here.

EXAMPLE: Buy August 100 Put for $3 (x100 = $300 total)

COST: What you spent on the put (In this example, $3 x100; $300)

THEORETICAL MAX PROFIT: If the stock goes to zero (not likely, but possible), you make the difference between zero and the strike, minus what you spent on the trade. (100 - $3 = $97 x 100 = $9,700)

THEORETICAL MAX LOSS: The price you paid for the put (In this example, $3 x100; $300)

BREAKEVEN AT EXPIRATION: There’s one breakeven point at the strike minus what you paid for the put. (100 - $3 = $97 breakeven)

BEST CASE TO NAIL IT: Stock moves lower immediately, resulting in a profit. A simultaneous rise in implied volatility could help, too.

WHAT CAN GO WRONG? Stock doesn’t fall quickly enough, or the stock is above the breakeven point as expiration nears.

The rate of time decay or a drop in volatility could exceed the benefit of any stock depreciation. This is why traders generally seek out long puts that have low historical volatility and longer expirations.

CLOSING THE TRADE: If the trade is profitable you can close it prior to expiration. Remember, try to keep things simple here. Buy low, sell high. Don’t forget, even if you get a big down move early in the life of the trade, time will begin to decay the value of the long put the closer you get to expiration. A good trader knows when to stay in a trade, but also when to get out. Sometimes, it can be better not to be greedy and, “ring the register,” (meaning take profits).

Of course, the stock might not go down enough to be profitable at expiration, stay where it’s at, or go up. In these cases, the long put will lose value. You can either cut your losses and sell the option for less than you bought it prior to expiration, or take the max theoretical loss and let the option expire worthless. In this case, the option will automatically be removed from your account after expiration.

If you want to exercise the long put and sell shares of the stock, that’s up to you—it’s your right under the contract. This is typically only done when the long put is in the money. At this point, you must either have 100 shares of the stock to sell, or be trading in an account that allows you to short shares of stock (Reminder: Robinhood Financial does not allow you to short stock). Don’t forget, being short stock has unlimited risk to the upside, because a stock can theoretically go up forever.

KEEP AN EYE OUT FOR… Your put will “auto-exercise” without your say-so if it’s in the money by $0.01 or more, if you hold it to expiration, and you have the available assets to exercise. When you exercise a put, you sell 100 shares of the stock at the strike price. If you don’t have the shares or are unable to short stock in your account, it’s possible that your broker could close your trade prior to expiration. It’s important to read and understand your specific broker’s options agreement to know if that is the case. But DON’T depend on this— and always keep an eye on your positions, particularly the week of expiration. A broker will simply look to get you out of the position, and not necessarily care when, or at what price. It’s best that YOU manage your trade prior to expiration. Nobody will care more about your position than you!

Selling time as a strategy

If you’ve been trading options for a while, you may have watched a stock move in the right direction, but your long option lost money anyway. Why? Time. Or more specifically, “time decay”—like a tax you pay daily when you’re holding an option. The longer you hold it, the bigger this tax gets each day and accelerates as you approach expiration.

All things being equal, no matter how much a stock moves, the option’s time premium loses a little each day because of time decay, as the graph below shows.

But what if you could flip the chart and with each passing day, time decay works in your favor? In fact, you can.

Shorting options revisited

Before diving further into these strategies, let’s touch on what it means to “short” an option. If you recall, shorting something means to sell it first, and buy it back later, hopefully for less than you sold it for. It can be done with stocks (just, not at Robinhood Financial) or options (yes, at Robinhood Financial, but with restrictions). When it’s done with options, you may never have to “buy back” the option because the aim is for the option to decay to zero on its own and expire worthless.

You’ll recall, being “long” (owning) an option contract allows you to either buy stock (if you exercise a call) or sell stock (by exercising a put) before expiration. The other side of that trade could be someone who is selling you that call or put short, which makes them obligated to sell the stock to you (if they’re short the call) or buy the stock from you (if they’re short the put). The table below breaks it down:

Selling single options

With certain “income” strategies, like the covered call and the cash-secured put (aka cash-covered put), you could sell options first (typically OTM options), which are “covered” by the stock you own (in a covered call) or the cash you set aside (in a cash-secured put). In either strategy, you collect the option premium up front, with the hope the stock doesn’t cross into the money on your strike. Meanwhile you’re letting time and volatility decay your option to lower prices or even zero at expiration.

There are four primary single-option selling strategies that most option traders learn at some point—short call, short put, covered call, and cash-secured put. The first two—the short call and put—are known as “naked” strategies because you’re exposed without a hedge (protection in case something goes awry). Since Robinhood Financial doesn’t allow naked option selling, we’ll focus on the covered call and the cash-secured put (both of which happen to be bullish strategies).

Both the covered call and cash-secured put allow you to sell (aka short) an option up front and collect the premium, as long as you own the stock (for a covered call), or have enough cash in your account (for a cash-secured put) to buy the stock. The goal is for the option to decrease in value or expire worthless on or before expiration, without much movement in the stock.

Since the risk profiles of these two strategies are essentially the same, whether you own the stock or not typically serves as the basis for your decision of which one to trade.

NAME: COVERED CALL

PROFIT GRAPH:

WHY TRADE IT? You think a stock is going up imminently, is going to trend sideways, or possibly take a small dip in price

OPTIMAL CONDITIONS: Medium to high volatility, bullish to sideways stock

SETUP: Long 100 shares of stock + short higher strike call (usually with a short-term expiration; ~20-45 days to expiration)

(On the Robinhood platform, this requires “legging” into the covered call by buying 100 shares of stock first, then selling the short call. Remember, to sell a covered call, your stock position must be in increments of 100 shares)

EXAMPLE: Buy +100 Shares at $50; Sell -1 August 55 Call for $2 (x100 = $200 credit received). Net cost = $5,000 - $200 = $4,800)

COST: Cost of long stock, less premium received for short call (In our example $48 per share, or $4,800)

THEORETICAL MAX PROFIT: Limited to the distance between purchase price of stock and the short call + short call premium received. The caveat of this is that if the stock moves far above that short call, you don’t get to keep any of it. It belongs to someone else at the strike you sold.

In our example, if stock is bought at $50 and a 55 call is sold for $2, the trade can profit a maximum of $7 (55 – 50 + $2 = $7 x 100 = $700)

Note: This also assumes that you are entering the stock and call at the same time. Sometimes, traders sell covered calls on stocks they have owned for some time. In this case, you could already have an unrealized profit or loss on your stock adding to your potential gains by selling the call, but also locking in a loss on a stock position. It’s important that you take into account the short call relative to the cost basis of your stock when calculating the long-term profit or loss of a stock that you have sold covered calls against.

THEORETICAL MAX LOSS: The price of the stock (stock could go to 0) minus the short call premium (In our example, $50 - $2 = $48 x100 = $4,800)

BREAKEVEN AT EXPIRATION: There’s one breakeven point (at expiration) at the stock price minus the short call premium (in our example, 50 - $2 = $48 breakeven price)

BEST CASE TO NAIL IT: The stock moves to the short strike by expiration, resulting in a profit in both the stock and the option. A simultaneous rise in implied volatility could help, too, but the rise in the short option would somewhat offset the rise in the long option.

CLOSING THE TRADE: The ideal scenario is for the stock to trade right up to and “pin” the short strike. This would allow you to keep the credit you received on the short call while participating in gains on the long stock position. If the call expires worthless, you keep the credit and the stock.

You can also buy in order to close the short option anytime before expiration. If you buy the call back at a lower price, you’ll have a realized gain on the short call. If you buy it back for more than you sold it, you’ll have a realized loss on the short call. Keep in mind that although you might lose money on the short call, the unrealized gains on your long shares of stock may be larger than the losses on the short call. The two could net together to create a net profit, which is why the covered call is actually a bullish strategy. Keep in mind however, you only realize gains on your stock when you decide to sell your shares.

If the stock shoots up in price, past your short call, you will be at max gain for the entire covered call. In this scenario, you can also let your stock get called away from you at the strike price. This would close your stock position and realize any gains or losses on the underlying stock. Don’t forget, you don’t participate in any stock gains above the strike price of your short call.

WHAT CAN GO WRONG? The stock drops more than anticipated and is below the breakeven point as expiration nears. This would allow you to keep the credit for selling the covered call, but the losses on the shares of stock would outweigh the small profits on the short call.

KEEP AN EYE OUT FOR… Stock and underlyings that are due to pay a dividend. One of the biggest risks of short calls is dividend risk. Dividend risk is the risk that you’ll get assigned on your short call option before the dividend’s ex-date. This includes short calls that are a part of a covered call. When this happens, your shares may be called away from you prematurely, taking you out of the position, and thus missing out on the dividend you would have received if you were simply long shares of the stock.

NAME: CASH-SECURED PUT (aka cash-covered put)

PROFIT GRAPH:

WHY TRADE IT? You think a stock is going up imminently, staying where it is, or only going down a little. Also, you’re willing to own shares of the underlying stock at the strike price of your short put.

OPTIMAL CONDITIONS: Medium to high volatility, bullish to sideways stock and market

SETUP: Sell a put short (you must have the money in your account equivalent to buy 100 shares at the strike price of the put, aka “cash-secured”)

EXAMPLE: Sell the $50 August put for $2

100 X $50 = $5,000 - $200 = $4,800 cost (what your broker withholds in your account)

COST: The strike x 100 shares, minus the premium received from the put (In our example, $4,800). (Remember, you’re collecting a credit for selling the put, but the amount of money required to buy the stock is set aside. Although you haven't bought anything, think of the cash as a future potential cost.)

THEORETICAL MAX PROFIT: Limited to credit received for selling the put (in our example, $2 x 100 = $200)

THEORETICAL MAX LOSS: The total between the strike and the stock going to zero, minus the credit you receive from the put ($50 - $2 = $48 to zero; x100 = $4,800)

BREAKEVEN AT EXPIRATION: There’s one breakeven point at the short strike minus the credit received (in our example, 50 -$2 = $48)

BEST CASE TO NAIL IT: Stock stays above strike at expiration, the put expires worthless, and you keep 100% of the premium taken in (in our example, $2 x100 = $200)

WHAT CAN GO WRONG? The stock sinks or is below the breakeven point as expiration nears.

If the stock goes in the money on the short put, you could be assigned and the cash you put up to sell the option would then be used to buy the stock. Not a big deal if you wanted to own the stock anyway, but if you don’t want to own a pile of stock in your account, be sure to exit your position before expiration!

CLOSING THE TRADE: Ideally, the stock stays above your short put and it expires worthless. You keep the credit and the option will be removed from your account after expiration.

You can also buy back the short put before expiration. If the stock rises, the short put will lose value and you can attempt to buy it back for a profit (sell high/buy low).

If the stock drops, the short put will gain value and if you want to avoid owning shares of stock, you can buy the put back at a more expensive price, realizing a loss.

Remember, many traders use the selling of puts as a way to get long the stock. Read that again. Many traders use cash-secured puts hoping to keep the premium, but also if they get put the stock, they don’t mind it, because it is a way to potentially buy shares at a lower price than what the stock was trading at when they sold the put.

KEEP AN EYE OUT FOR... As the stock climbs, the change in the value of the put will decrease, meaning the option will be less sensitive to the rising stock price. This means that although your short put will have an unrealized profit, you’ll be risking the chance that the stock turns around, in exchange for squeezing out the last few pennies of premium in the short put. To avoid this, some traders look to “roll” their short puts up, which is trader-speak for buying back the profitable short put (at less than max profit) and establishing a new short put at a higher price.

Congratulations. You’ve made it through the first four options strategies. It’s a lot of information to take in, so take your time and go back to make sure you understand these strategies before considering them in your account. Options take time and practice to learn and grasp. Pat yourself on the back, you’re well along the educational journey now!

Next Up: Spreads: the building blocks of Options trading

Disclosures

Any hypothetical examples are provided for illustrative purposes only. Actual results will vary.

Content is provided for informational purposes only, does not constitute tax or investment advice, and is not a recommendation for any security or trading strategy. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results.

Options trading entails significant risk and is not appropriate for all customers. Customers must read and understand the Characteristics and Risks of Standardized Options before engaging in any options trading strategies. Options transactions are often complex and may involve the potential of losing the entire investment in a relatively short period of time. Certain complex options strategies carry additional risk, including the potential for losses that may exceed the original investment amount.

Robinhood Financial does not guarantee favorable investment outcomes. The past performance of a security or financial product does not guarantee future results or returns. Customers should consider their investment objectives and risks carefully before investing in options. Because of the importance of tax considerations to all options transactions, the customer considering options should consult their tax advisor as to how taxes affect the outcome of each options strategy. Supporting documentation for any claims, if applicable, will be furnished upon request.

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