by zahlman | 2025-11-04 19:14:29+00:00
You buy an option that has a particular cost, which gives you the right to sell stock at a specific price in the future (the "strike price"), within a certain time frame. Typically, these are denominated so that you contract to buy or sell 100 shares. In a "naked" put, you don't actually have the stock that you propose to sell. In the future, you plan to "exercise" the option by buying the stock at the market price. and then immediately sell it at the contracted price.

A put option represents a belief that the price will fall, which makes "right to sell the stock" valuable. Similarly, a call option represents a belief that the price will rise. Both can be bought and sold; you do not "make" them but rather trade in them, just as you would in stock. But the relationship between the stock price and the result from an option is not linear; selling a put and buying a call are both nominally "long" the stock, but are not equivalent.[0]

When you buy an option, you are always immediately out for the cost of the option itself (the "premium"). This is separate from the strike price. It's the market's assessment of how much your "right to sell later" is worth, in itself. By doing this, you are speculating that you can recover that money later, based on how the stock performs. (Depending on your strategy, this can involve buying or short-selling the "underlying" stock, as well as other options.)

So if you buy a put, you pay money (the premium) up front, and you potentially just lose that money completely. Sane options strategies take your entire portfolio into account, and use options to hedge the risk profile of the rest of the profile (rather than trying to use the rest of the profile to justify taking on risk using options).

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Some details, and further exploration.

Options represent essentially zero-sum speculation on top of the actual price movement. For example, holding everything else constant, a call option increases in value as the price of the underlying increases (the right to buy stock at a fixed price becomes worth more, when the stock is worth more). When a company does well, everyone who holds the actual stock shares in the company's good fortune; but the profit of call holders comes at the expense of those who sold (or "wrote") those calls.

The option is priced according to market expectations of risk (how likely is it that the stock's price will fall below the chosen mark?), and according to duration (the longer you reserve the right to exercise the option, the more likely it is that you'll get a profitable opportunity; therefore, the more valuable and thus expensive the option is). For long-term options (especially now that interest rates are non-trivial) there's a second meaningful duration factor: buying an option comes with the opportunity cost of not holding cash (or treasury bonds) for that period, and that also has to be priced in.

"American" options give you the right to exercise at any point before the deadline; "European" options only allow you to exercise at the deadline. This is also priced in; having more flexibility is worth more.

If you have chosen well, the market price for the stock goes down by a lot. This allows you to profit when you exercise the option.

If you have chosen poorly, you never get the opportunity to profit. Your options "expire worthless"; an option to sell at a point that has already passed has no value. You have been left holding the bag.

In between, you might exercise in a way that recovers only part of the premium you paid.

Much riskier is to sell options against securities you don't hold. (You will likely be legally barred from attempting this at all, and even wealthy experienced traders will be required to hold some percentage of the security value that their options represent.) You are hoping that the option expires worthless, so that you simply claim its value uninhibited. If it doesn't, you may be "assigned" i.e. legally on the hook for someone else's exercise of the option. If you sold a put, you may be forced to pay an inflated price for a stock that crashed. If you sold a call, you may be forced to acquire stock in order to sell it at a discount in order to fulfill your option. The potential loss for selling a put typically far exceeds the maximum potential profit; the potential loss for selling a naked call is unlimited (as we suppose the stock's value can go to infinity).

But if your sale of a call is "covered", or your sale of a put is "cash secured", this means you fully own the security (underlying stock, or liquid assets respectively) corresponding to the option. The cash secured put still incurs the risk of wiping out your entire cash supply, much as if you'd simply bought 100 shares directly, and it puts a hard limit on your upside. But it lets you profit from the stock without actually holding it.

Given sensibly chosen strike prices, covered calls actually end up with a similar risk/benefit profile. As the stock goes to zero, all you end up with is the option premium, because you were holding the stock. If the stock does well, your net profit is limited to the option premium, because the profit from holding the stock cancels out the liability of the option. (Equivalently: you are required to sell the stock at the strike price, but you already have that stock; no matter how high the underlying stock value gets, you can only claim the strike price.)

[0]: Doing both gives risk exposure roughly equivalent to holding the stock, without actually buying it. This is called a "synthetic long". As you can imagine, that is effectively unlimited leverage in itself, and if you attempt it you will be required to hold a significant amount of cash to limit your leverage, and jump through a lot of regulatory hoops to prove both your competence and solvency. I didn't mention this at the start, because you need the details to understand it.