Should I Buy a Put or Sell a Call?
01/31/2011 11:18 am EST
In my recent options class at our center in New York City, some of the attendees were having a hard time understanding the main difference between a short put and a long call. In this article, I will discuss and compare the intricacies of a long call versus the intricacies of a short put.
First, I will start by explaining each of them and distinguish them by their differences. In our Online Trading Academy basic two-day options trading class, we present four possibilities of trading options. They include two bullish strategies, selling a put (-p) and buying a long call (+c), as well as two bearish strategies, selling a call (-c) and buying a long put (+p). Due to the scope of this article, I will focus only on –p equaling the +c. These two symbols are the shorthand frequently used by the professionals. Figure 1 below addresses side by side the intricacies of a long call on the left and the short put on the right.
Notice that the left side is self-explanatory, while the right side needs only one additional remark. Although selling a put is a bullish strategy, we at Online Trading Academy define it as willingness to buy, or W.B. Moreover, this willingness to buy brings in some compensation to the put seller in terms of premium received. In order to make this point even more clear, I will use a simple example. For instance, if a stock is trading at $25.68 and an option trader is considering taking a bullish trade, he or she has two choices depending on the implied volatility (IV): Selling a put when the IV is high, or buying a call when the IV is low.
Part One: Buying a Long Call
If the volatility is low, as it currently is on most issues, then he or she could purchase a long call. The option chain of a particular stock (XYZ) at the time of writing this newsletter was displaying the ask/offer quote for a 25-strike-price call at $2.20. The strike price of 25 is the (ATM) at-the-money option, and out of $2.20 only $0.68 is the true (intrinsic) value, while everything else is fluff, or time (extrinsic) value. The fact that the trader has purchased the call for a premium of $2.20 means that the trader is starting his option position by being in the hole. For the trader to break even at expiry when the time component is totally taken out of the equation, the underlying needs to be at least $27.20.
Is that really the best way to trade? Well, if the implied volatility is low and the trader feels confident based on his or her technical analysis, then definitely, that is one of the choices available. The problem that I have with going long on a call option is that in terms of probability, it is a low-probability trade because the stock needs to move. In fact, we all know that the market can, at any given time, go up, down, or sideways. The fact is that in the case of a long call, the buyer is not profitable unless the product moves in the direction of the forecast. Mathematically speaking, one divided by three (directions the stock can go) gives only a 33% probability that XYZ might move in the direction of the forecast. In other words, the trader is forcing the stock to do what he or she wants. Not the highest-probability trade because to be profitable, the prediction must be correct.
Part Two: Shorting a Put or Selling Cash-Secured Puts
Let us move to the second bullish possibility that an option trader has: Shorting a put or selling a cash-secured put. This strategy is more costly than the first one due to the outlay of capital that is required. Also, the underlying assumption is that the seller of a cash-secured put truly has the intention of owning/buying that stock. Hence, let us go through the specifics of the right side of the graphic above.
The stock was trading at the same price as when we looked up the long calls, but in this case, we are looking at the 25-strike price on puts. The short 25 put gives us an obligation to buy the stock, yet at Online Trading Academy, we choose to rename that "obligation" as a "willingness to buy." It is all a matter of perspective. Obligation might have some negative connotation to it, while willingness has a non-threatening ring to it. Regardless of the point of view, the seller of the 25 put has taken up a commitment that needs to be kept. Due to the seller's "willingness" to buy, he or she is being compensated up front by receiving premium in the amount of $1.50, and the fact that money was taken in means that the trader is opening his or her position in the black; quite a different feeling than being in a hole with a +c.
Next, let us address the need to be correct. If the trader is incorrect and the stock falls below $25, then he or she gets the stock at the pre-agreed-upon strike price, which is $25. Even in this case, there can still be a profit, as the trader's profitability depends upon whether the price action is above or below the breakeven point (BEP). The BEP in our case is 25 minus the premium received.
Lastly, let's look at the low expectation of this trade. The stock can still move up, down a little, or sideways, yet the seller does not sweat much over it. If the stock goes up, then the put seller does not get his or her original intention of stock ownership. However, the premium is kept no matter what. In other words, the trader was wrong, but he or she gets paid. The second scenario is a sideways movement; the trader still did not get what he or she wanted, and yet the premium is there to keep. The third scenario is that the stock goes down and the trader ends up owning the stock at a discount.
In conclusion, in this article, I have discussed the intricacies of a long call versus the intricacies of a short put. Hopefully, my bias did not ruin the point that I was attempting to make. Be wise, be informed, and be well educated as to the inner workings of options before trading them. Compare them against one another so you can select the higher-probability trade.
Have great trading week.
By Josip Causic, instructor, Online Trading Academy