This article will explore four types of options: the basic two, calls and puts, alongside covered calls and naked calls. Each option type carries a unique set of risks and rewards you should be aware of before making investment decisions.
We’ll look at each type and discuss when they might be the right choice for you. By the end of this article, you’ll better understand how to use options to your advantage in today’s market.
What are the four different types of options and their definitions?
Let’s have a look at the four different option types.
Call option
It gives the holder the right to purchase an asset at a specified cost, called the strike cost, on or before an expiration date.
If the underlying asset is above the strike price at expiration, then the option is said to be in the money, and the holder will make a profit.
If the underlying asset is below the strike price at expiration, then the option is out of the money and the holder will lose money. Calls are typically used when you expect the underlying asset’s price to increase.
Put option
It gives the holder the right to vend an asset at a specified cost, called the strike price, on or before an expiration date. If the underlying asset is below the strike price at expiration, then the option is in the money and the holder will make a profit.
If the underlying asset is above the strike price at expiration, then the option is out of the money and the holder will lose money. Puts are typically when you expect the underlying asset’s price to decrease.
Covered call
It is an options strategy involving buying shares of an underlying asset and selling a call option on those shares. The strike price of the call option should be equal to or greater than the current market value of the shares.
Covered calls are often used by investors looking to generate income from their portfolios while still holding on to their underlying assets.
Naked call
It is an options strategy that involves selling a call option without owning the underlying asset. It is a high-risk strategy because you are exposed to unlimited downside if the underlying asset price goes down.
How can you use each type of option to your advantage?
Now that you know the four different types of options let’s look at how each can be used to your advantage.
Call option- If you expect the underlying asset price to increase, then buying a call option is an excellent way to profit from that price movement. You will make money if the asset price goes up and lose money if it goes down.
The key is to choose an expiration date that gives you enough time for the price to move in your favour but not so long that it becomes too risky.
Put option- If you expect the underlying asset price to decrease, then buying a put option is an excellent way to profit from that price movement. You will make money if the asset price goes down and lose money if it goes up.
The key is to choose an expiration date that gives you enough time for the price to move in your favour but not so long that it becomes too risky.
Covered call- If you want to generate income from your portfolio while still holding on to your underlying assets, then selling covered calls might be a good strategy. You will receive premium payments from selling the call options and will still benefit from any upside in the underlying asset’s price.
You must know the risks involved, including having your shares called away if the underlying asset price increases significantly.
Naked call- If you are bullish on an underlying asset and expect the price to increase significantly, then selling naked calls might be a good strategy. You will receive premium payments from selling the call options but will be exposed to the unlimited downside if the underlying asset’s price goes down.
When is it best to use these options?
The best time to use each option will depend on your personal investment goals and objectives. Buying call or put options might be a good strategy for quick profits.
However, suppose you are looking to generate income from your portfolio or are very bullish on an underlying asset. In that case, selling covered or naked calls might be a better strategy.
Options can be a helpful tool for investors of all levels of experience. Understanding the different types of options and how they can be used to your advantage before making any trades is essential. Click here to contact a broker today.
Examples of each option in action
Let’s look at examples of each type of option in action.
Call option
You expect the price of ABC Corporation’s stock to increase and decide to buy a call option with a strike cost of $50 and an expiration date of one month. The stock’s current market price is $49, and the premium for the option is $2.
At expiration, the price of the stock is $51. The option expires in the money, And you exercise your option to buy the stock at $50. You sell the stock immediately at the market price of $51 and make a profit of $1 per share.
Put option
You expect the price of XYZ Corporation’s stock to decrease and decide to buy a put option with a strike cost of $50 and an expiration date of one month. The stock’s current market price is $51, and the premium for the option is $2.
At expiration, the price of the stock is $49. The option expires in the money. And you exercise your option to sell the stock at $50. You buy the stock immediately at the market price of $49 and make a profit of $1 per share.
Covered call
You own 100 shares of ABC Corporation’s stock and decide to sell covered calls with a strike price of $50 and an expiration date of one month. The stock’s current market price is $49, and the premium for the option is $2.
At expiration, the price of the stock is $51. The option expires in the money. And you are assigned 100 shares at $50 per share. You sell the stock immediately at the market price of $51 and make a profit of $1 per share.
Naked call
You expect the price of XYZ Corporation’s stock to increase. And you decide to sell naked calls with a strike price of $50 and an expiration date of one month. The stock’s current market price is $49, and the premium for the option is $2.
At expiration, the price of the stock is $51. The option expires in the money, and you are assigned 100 shares at $50 per share. You sell the stock immediately at the market price of $51 and make a profit of $1 per share.
However, if the stock price had decreased to $48 at expiration, you would be assigned 100 shares at $50 per share. You would have to buy the stock at the market price of $48, which would incur a loss of $2 per share.
As you can see, each type of option has potential profits and losses. It is essential to understand the risks involved before making any trades.
