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On Saturday, I invited my friend Keith Kaplan, the CEO of TradeSmith, to share some investing wisdom about trading options.

Options are always a hot-button topic with investors, so today, I’ll go into more detail on a few different types of option trades, how to make money using options, and the risks involved.

There are two types of options: calls and puts.

Calls give the buyer the right, but not the obligation, to buy a stock at a specific price by a specific date. The seller of the call must deliver the stock if the buyer requests it.

For example, if Merck (NYSE: MRK) is trading at $116, an investor can buy one November $125 call for $0.70. Options contracts are usually for 100 shares, so that means that the buyer is paying $0.70 per share upfront ($70 total) for the right, but not the obligation, to buy 100 shares of Merck at $125 per share ($12,500 total) by November 15. (Most options expire on the third Friday of the month.)
 

Buying Calls

Why would an investor spend $70 for the right to buy Merck at $125 if it’s trading at $116? Likely because they think the stock will be worth more than $125 by November 15. If they’re wrong, it will cost them only $70.

If they buy the stock at $116 and it falls to $110, they’ll lose $600 ($6 per share x 100 shares). Buying a call caps their loss at $70. If they’re right and the stock is worth more than $125, they can buy the stock at $125, or they could sell the call for a profit since it will have increased in value.

A moderate move in a stock can lead to enormous gains in the calls. If Merck trades up to $130, that’s a 12% move in the stock, but the calls will be worth at least $5 because the stock is $5 above the agreed-upon price. The $0.70 calls would now be worth $5, or more than 7 times the original price. The stock moved 12%, but the option gained over 600%.

Buying a call lowers your potential loss and capital outlay but still allows you to participate in the upside if the stock moves higher. The downside is that stocks don’t always cooperate according to your timeline.

If Merck is trading at $124.50 on November 15, the call will expire worthless. If Merck takes off and hits $140 the following week, the call buyer is out of luck. The call has already expired.

But you don’t have to only buy calls. You can also sell them.
 

Selling Calls

Selling calls is a great way to generate income, but I recommend doing it only with stocks you own already. Otherwise, the risk is too high. Here’s what I mean.

Let’s say you own shares of Merck and you want to generate some extra income. You sell the November $125 calls for $0.70.

That means that at any time before the third Friday in November, the buyer can demand your stock. They won’t demand the shares if they’re trading below $125 – but if the stock is trading at $140, you will be required to sell your shares to them at $125 if they demand it.

The call buyer is placing a bet that the stock is going to go higher. By selling the call, you become the bookie and take that bet. Because the call costs $0.70, you’re getting paid $70 to agree to provide Merck shares at $125. If the calls expire worthless, you keep the $70.

If the stock moves higher, you can always buy back the calls. The price could be higher or lower than what you paid depending on different variables, but that’s a route you could take if you didn’t want to give up your stock – as long as the buyer hasn’t demanded it already.

When you own a stock and sell calls against it, the strategy is known as selling “covered calls.”

This is the only way that you should sell calls.

Here’s why: Let’s say you sell the Merck November $125 calls for $0.70 but don’t own the stock. You collect the $70.

Merck shares start rising, and then they start soaring. In early November, the stock is trading at $200 and the buyer demands the shares. Because you don’t actually own the shares, you’d have to go into the open market and buy 100 shares for $200 each ($20,000 total) in order to sell them at $125 ($12,500 total). Your loss would be huge.

When you sell a call without owning the stock, your potential losses are unlimited.
 

Buying Puts

Puts are like insurance contracts. A put gives the buyer the right, but not the obligation, to sell a stock at a specific price by a certain date. The seller of the put must buy the stock if the put buyer demands it.

Puts are bets that the stock price will fall. An investor can speculate that a stock is going to drop by purchasing a put, or they can use puts to hedge their position.

If someone owns Merck at $116 and is concerned that the price could drop after the company reports earnings in October, they could buy the November $110 puts for $1.40. That means their loss would be capped at $6 per share, or 5% of the stock price.

If the stock drops to $90, they can still sell their shares at $110, or they can take profits on the puts (which will have increased in value) and keep the stock. If Merck never falls in price, the investor loses the $1.40 per share, or $140 total. It’s like buying insurance on your stock.
 

Selling Puts

The seller of the put acts as the insurance company. Writing insurance tends to be lucrative, but you must keep in mind that occasionally there is a disaster, so you need to be prepared.

I recommend selling puts only on stocks you’d like to own at a certain price.

Let’s say that you like Merck but believe $116 is too expensive. However, you’d be happy to own it at $110.

You could sell the November $110 put for $1.40 and collect the $140. If Merck never reaches $110, you could keep the $140, like an insurance company keeps a premium when no claim is made.

If the stock drops to $110 or lower, you (the put seller) may be required to buy the stock at $110. You’d still keep the $1.40 premium you collected, which lowers the real price paid for the stock to $108.60.

The risk is that the stock will drop well below $110 and you’ll end up paying $110 for a stock that’s now worth, say, $90. But remember: You previously said you’d be happy to own it at $110.

Like selling a call, you can always buy the put back before the stock is sold to you if you no longer want to buy the stock. You may take a loss on the puts, but at least you won’t be stuck with a stock you no longer want.
 

An Overlooked Source of Income

Buying puts and calls allows you to speculate on a stock’s direction without a large outlay of capital. Your loss is capped, but the odds of success are lower because of the time constraint.

Selling puts and calls is a terrific way to earn income as long as you’re smart about managing the risk.
 

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