Buying Calls vs. Selling Puts

I received an interest question today, about options.

“FS i’d like to understand the difference between selling puts and buying calls. In both cases, it seems you are bullish on a position. For instance, if I am bullish on Apple, both buying calls or selling puts seem to make sense and seem profitable. Tyvm.”

When you buy a call, you limit your risk to how much money you spent on those calls. Worst case scenario, your calls will expire worthless and you’ll lose whatever money you paid for those calls. So if you pay $5 for a call, the worst that can happen is that you will lose your $5.

When you sell a put, your risk is a little bit more complicated to calculate: your biggest loss is the strike minus the premium.

For instance, say ABC Inc. is trading at $90. You sell a put with a strike of $100 for $25. In other words, someone has the right to sell you 100 shares of ABC Inc. for $100 per share. Remember every option contract is for 100 shares. Your maximum loss is 100 * ($100-$25)=$7,500. Your max loss will happen if ABC Inc. goes from $90 to $0, i.e. it goes bankrupt.

 

Calls and puts by nature have a negative theta. What we mean by that is that if nothing else changes, their theoretical price will go down every day. In the example above, if ABC Inc. remained at $90 forever and nothing else changed (risk-free rate, dividend rate, volatility, etc.), then our put would be worth a little bit less every day ($24.90 after a day, $24.81 after two days, etc.) and so would the calls. This amount depends on several factors, also theoritical. For instance, it would converged to its exercice value. If ABC remained at $90 forever, then the put would eventually be valued at $100-$90 (strike minus stock price). In this case, you would exercice your puts to sell ABC Inc. at $100, then immediaately buy it back at $90.

Please keep in mind I included the word “theoretical” above. Most people use Black-Scholes to price options, which is an absolutely terrible model. It’s very possible, and even likely, that option prices could vary significantly from their theoretical prices and I’ve seen options trade at ridiculous price, especially after the stock moves a lot. Always keep in mind that the only thing that truly determines the price of an option is what people are ready to buy and sell it for.

Still, no matter the model you use, options always lose value with time. Why? Because options have an expiration date and the close you are to the expiration date, the less likely the stock will jump or crash (because there’s less time left, thus less time where stuff can happen).

If you buy a call, your position has a negative theta, meaning that if nothing else changes, you will lose money every day. More than that, even if the stock goes up, you could still lose money. For instance, let’s say you bought a $100 calls on ABC Inc., which still trades at $90. Even if ABC Inc. rose to $95, it’s possible that your call’s value would go down, just because time has elapsed (or volatility went down, for instance).

If you sell a put, your position will have a positive theta. Why? Because you are -1 on a negative thing, thus two negatives, thus positive. Even if the stock doesn’t move, you will earn money every day because the value of the put will go down. Keep in mind, however, that your potential loss when selling puts is usually much higher.

From a risk-neutral point of view (i.e. assuming the market is balanced and fair), both buying calls and selling puts have their pros and cons and none is better than the others. Both offer very different risk profiles (as explained above) with very different payouts, odds and final outcomes. One more element: if you were go short on a call, for instance, your potential risk is theoretically unlimited. If you sell a call on ABC at $10 and ABC kicks off to $1,000,000,…, you are facing a huge headache.

Personally, I rarely, if ever, buy calls. Very rarely in my life have I made big money buying calls, but when I have, I have to admit I made plenty. In my lifetime, I think I’ve had over a million dollars of calls that expired plain and simply worthless. In the example above, if you bought a call on ABC Inc. with a $100 strike and it closed at $99.99 at your expiration date, well, you’d lose 100% of your money.

I find that, in general, calls are too expensive for what they are. That being said, puts expose you to a much bigger potential loss. Whenever I play earnings, I like to sell slightly OTM puts and cover with lower puts. For instance, if FB trades at $100, I might do the following vertical spread:

  • Sell a $98 put @ $3.00
  • Buy a $92 put @ $1.00

The second leg of this trade will protect me against the rare but very painful potential crash. With this trade, I am hoping that FB closes at $98 or over at expiration date. That way, I get to keep the entire premium, that is, $3.00-$1.00=$2.00 per contract, or $2.00 * 100 = $200 total. Buying $92 puts will protect me from catastrophes. If Facebook crashes to $75, I won’t lose my shirt. Without that $92 put, my loss would be 100 * ($98-$75) – 100 * $2.00 = $$2,100. With it, my max loss on that trade would be 100 * ($98-92) – 100 * $2.00= $400. This would happen if Facebook closed at $92 or lower.

TLDR: Buying calls limit your exposure and potential losses, gives bigger payouts less often. Selling calls exposes you to huge potential losses and gives smaller payouts more often.

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