by Dawn Pennington 09/12/08
For the long stock investor, the purchase of put options against the position serves as insurance. This strategy, known as a "married put," serves as a protective floor in case the price of the underlying security drops. While the long investor's hopes for the stock are much different than the individual who simply buys a put option (without holding the stock), the put allows the long investor to sell his or her shares at the strike price if they decrease in value.
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On the flipside, writing calls comes with unlimited risk and limited reward. Going short means that you collect a premium right away, as opposed to laying out cash as you do with the purchase of a put. Your goal is the same when you short a call as when you buy a put -- to see the stock price drop in value. If the stock goes down to $20, being short an XYZ 25 Call would mean that you had correctly called the direction of the stock, and you would be able to keep the premium you collected when you initiated the trade.
The risks are substantially different with short calls versus long puts. As the short-seller, you may be obligated to take a short position in the underlying instrument if the call buyer chooses to "assign" you to sell shares at the strike price to them. If the stock goes up to $30, the holder of your XYZ 25 Calls can buy the stock from you at $25 per share, but in order to cover that obligation, you'd need to buy shares at market price, or $30 -- $5 more than they're presently worth. Ouch!
You can make either strategy work for you and your portfolio, as long as you know the risks and are prepared to take quick action if your trade starts to turn against you.
Read This Before You Buy Another Stock
A savvy stock position can start with a single options trade.
This technique can help you breathe a sigh of relief as it aims to relieve a 'choking' portfolio.
If you are familiar with buying calls and puts, we'll show you how to buy them even cheaper.
Anatomy of a Stock Option Ticker
Option tickers may look like a bowl of alphabet soup to you, but each letter means something.
