Buying Calls and Puts

The method

Use the same sequence every time, and write it down rather than doing it in your head.

First, identify the position and its direction. Long call is bullish; long put is bearish.

Second, write the premium. For a long position, the premium is the entire amount at risk, so maximum loss is the premium — always, with no exception. That is one of the three numbers free of charge.

Third, find breakeven by asking what the underlying must do for the position to recover the premium.

Fourth, find the remaining extreme by pushing the underlying as far as it can go in the favourable direction. For a call that is upward and unbounded; for a put it is downward and stops at zero.

Work per share throughout and multiply by 100 at the end. Practise until the sequence runs without deliberation, because under time pressure the failure is never conceptual — it is a candidate reasoning correctly and slowly on question sixty-one of a hundred and twenty-five.

The long call

An investor buys 1 XYZ October 50 call at 4. XYZ is at 48.

Maximum loss: the premium, $400. If XYZ never exceeds 50, the call expires worthless and the entire premium is lost. Note that the loss is capped, which is the long call's central appeal for a bullish investor with limited capital.

Breakeven: the stock must rise past the strike far enough to recover the premium. Breakeven equals strike plus premium, which is 54.

Maximum gain: unlimited. There is no ceiling on the stock price, so there is no ceiling on the gain.

At 60, the call is worth 10 intrinsic; the investor paid 4; the gain is 6 per share, or $600. At 54 the position is flat. At 50 or below it is worth nothing.

Why an investor buys a call. To speculate on a rise with limited capital and a known maximum loss. To lock in a purchase price on a stock they intend to buy later — the premium buys the right to acquire at 50 whatever happens. And, importantly, to hedge a short stock position: a customer who is short XYZ faces unlimited upside risk, and buying a call caps the price at which they can be forced to cover. That last use is the exam's standing answer to 'how does a short seller protect against a rise.'

The long put

An investor buys 1 XYZ October 50 put at 3. XYZ is at 52.

Maximum loss: the premium, $300.

Breakeven: the stock must fall below the strike far enough to recover the premium. Breakeven equals strike minus premium, which is 47.

Maximum gain: bounded, because a stock cannot fall below zero. With the stock at zero the put is worth its strike, 50, against a premium of 3, so the maximum gain is 47 per share, or $4,700. Maximum gain equals strike minus premium.

That asymmetry between the long call and the long put is a favourite question. A long call's maximum gain is unlimited; a long put's is the strike less the premium. Candidates who answer 'unlimited' for a put are answering the call's question.

Why an investor buys a put. To speculate on a decline with limited risk — and note that this is a far better shape than selling short, where the loss is unlimited and margin is required. To hedge a long stock position, which is the protective put covered in lesson 6.5. And to lock in a selling price on stock they own without selling it.

One case worth having ready. A customer who owns appreciated stock, is worried about a decline, and does not want to trigger a taxable sale this year, should buy a protective put. It caps the downside, it costs the premium, and it does not dispose of the shares.

Reading a question quickly

The exam's option questions come in a small number of shapes, and recognising the shape is most of the speed.

'What is the maximum loss?' For any long position, the premium. Answer it before reading further.

'What is the breakeven?' Strike plus premium for a call, strike minus premium for a put. Two facts, and they generalize: for anything built out of calls, breakeven sits above a strike; for anything built out of puts, below.

'At what price does the investor begin to profit?' The same as breakeven, phrased to see whether you notice.

'What is the investor's gain if the stock is at X and the option is exercised?' Compute intrinsic value at X, subtract the premium, multiply by 100. Watch for questions where the option is out of the money at X — then the investor lets it expire and loses the premium, and 'exercise' is a distractor.

'Which position protects a short stock position?' Long call. 'Which protects a long stock position?' Long put.

One habit is worth more than any of these: sketch the position. Two axes, the strike marked, the premium marked, the hockey-stick drawn. It takes eight seconds and it eliminates the direction errors that account for most of the marks lost in this module.