Lesson 4: Strategies based on buying a call or put option
Let’s explore some specific strategies that use options.
CIBC Investor's Edge
3-minute read
Now that you have some basic understanding about the way options work, let’s explore some specific strategies that use options.
Buying a call or put option to mimic stock performance
A common reason option traders buy calls or puts is to mimic the performance of a stock.
As explained in lesson 1, the value of an option is based on the price of the underlying stock, among other things. Generally:
- Call option prices tend to increase when the underlying stock price increases. Buying a call allows you to potentially benefit from a stock’s upside move.
- Put option prices tend to increase when the underlying stock price declines, so buying a put lets you potentially benefit from a downside stock move. Investors who short sell stocks also want to benefit from a decline in stock prices — they just use a different technique.
If you believe a big move is coming in the stock price, but you’re unsure which direction the price is headed, you might buy both a call and a put.
You can also use calls or puts as a kind of insurance for your portfolio holdings, as we describe in the next section.
Buying a put to limit your losses from a decline in a stock holding
This is a method to protect an existing stock holding when you fear the stock could decline in the short term. In this case, you would rather not sell the stock because:
- You want to hold it for the long term, perhaps to collect the stock’s substantial dividend.
- Your fears may not be justified but, just like with travel insurance, you’d like some protection just in case.
You buy a put, which will generally increase in value as your stock’s price declines. The gain on the put can offset some of the loss on the stock. In this scenario, you could sell the put at or before expiry and take a profit if you’re correct about the stock’s decline. Remember however that the put will lose some of its value as its expiry date approaches due to time value erosion. If you keep the put until expiry and the stock closes out-of-the-money, you’ll lose the original amount you paid for the option, plus commission.
At expiry you could also exercise the put and sell your stock at the exercise price, if you’ve decided that you no longer want to keep the stock.
Buying a call to limit your losses when you hold a short position
As in the earlier example, this is a method to protect an existing position — in this case, a short stock position when you fear the stock could rise. Again, your fears may not be justified, but you’d like some protection just in case. You would rather not cover your short sale now because you believe the stock is headed lower in the long term.
You buy a call, which will generally increase in value as your stock’s price rises. The gain on the call can offset some of the loss on the short position. In this scenario, you could sell the call at or before expiry and take a profit if you’re correct about the stock’s rise. Remember however that the call will lose some of its value as its expiry date approaches due to time value erosion. If you keep the call until expiry and the stock closes out-of-the-money, you’ll lose the original amount you paid for the option, plus commission.
At expiry, you could also exercise the call and cover your short position by buying the stock at the exercise price, if you’ve decided you no longer want to hold the short position for the long term.
