Options can be hard to understand, but once you do, a new world of investing opportunity opens up to you.
In this clip, Motley Fool Options analyst JP Bennett answers a listener question about when it would be appropriate to put both a call option and a put option on the same stock. He also answers another question about what fundamentals to look at when you're looking to buy a stock versus buy a long option on the stock and when an investor might want to buy both.
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A full transcript follows the video.
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This video was recorded on March 24, 2017.
Dylan Lewis: "In what situation, if ever, would you have a call option and a put option on the same stock?" This might be more of an advanced option concept that we're going to touch on here?
JP Bennett: There are straddles, there's strangles, there's a bunch of different strategies --
Lewis: More of that jargon. [laughs]
Bennett: -- iron condors, there's a bunch of different strategies that could utilize that. Basically, thinking about those strategies, if you're buying them, you probably want to have the stock move significantly. If you think about a straddle or strangle, you're basically using puts and calls that are relatively close together -- they're either the same strike price, or maybe they're off by $5. So what you want to happen is, if you're long those, you want the stock to move really sharply in either direction so that one is going to end up worthless but the other is going to end up with a lot of money. So, you go into earnings, you buy the puts, you buy the calls, the stock spikes hard, the puts end up worthless because they're out of the money, but the calls end up with a lot of value, so you make a lot of money that way. Or, you can do the opposite. A strategy that we've used, I think we have one or two that are currently active, and we actually have one that is active on the other service I work for, Motley Fool Pro. Basically, what it's referred to is a covered straddle. Basically, what you're doing there is instead of buying those options and hoping or praying that the stock is going to move a ton, basically, we have stocks that we think are relatively steady, so we're looking to double our income. We own those shares, we own 100 shares, and then we're also setting up a covered call by selling calls against that, but we're also selling puts. We're also saying, "We'd like to buy more shares if it falls; if not, we're going to generate extra income." So, that can be an example of, potentially, a higher success rate strategy, in my opinion.
Lewis: The thought there is, you're betting that it's going to stay within a pretty tight band over the course of the contracts.
Bennett: Yes. And if it moves sharply in either direction, we're OK with that.
Lewis: Another question Patrick had, "Are there different fundamentals to look at when considering buying a long option versus buying a stock? Or, maybe, when should I buy both?"
Bennett: This tees up one of the cornerstones of how we invest using options. We basically repeat it until we're blue in the face whenever we have live chats and meet members that are considering joining Options or something along those lines. We are investors first, and we look at the businesses, we study the businesses, we come up with what we think the stock is worth, our estimate of what the intrinsic value of the underlying stock is. And only after we have a stock that we really like, we feel comfortable with understanding what the future holds for the business and what the value of the stock is, then do we look to see if the options market is providing us with a strategy that we can utilize. We don't let the tail wag the dog in terms of, "Those puts look really good, I'm going to look at the stock, but my mind is already made up. The company could be completely garbage, but those puts pay so good, I'm just going to write them anyway, fingers crossed." We never do that. It's always, business first, options strategy second. That's basically, the reader there is hitting the nail on the head is look at the business, find businesses and stocks that you like. Then look to see if you have an options strategy.
Lewis: He gets at, in the second half of that, "When should I do both?" You were talking about several strategies before where you own the stock, and then you're also, possibly, buying long options, or using instruments based on where you think the stock price might be going in the next couple months or years.
Bennett: Yeah. If you're really bullish on a stock, you can basically set up options strategies that have leverage upside. Going back to a strategy that is still ongoing but pretty close to being set in stone is, we have what's referred to as a bull call spread on Apple(NASDAQ: AAPL). We set it up last year, when we were having the market sell off and everybody was panicking. Basically, we bought calls that strike at $85, and we sold calls that strike at $90. There's a $5 increment there, which means the max payout is $5. If the stock ends above $90, the calls that you own at $85 end up being worth $5 more than the calls that you sold. So, that's what you're going to make. And we basically paid a little bit under $2.50 for that right. So, basically, there's an opportunity to double your money as long as the stock finishes above $90. And with the stock at $140, even though you would have done really well if you'd just bought shares, the return that we were able to generate using that strategy is obviously much higher.
Lewis: And that's where leverage comes into play.
Dylan Lewis owns shares of Apple. JP Bennett owns shares of Apple. JP Bennett has the following options: short January 2018 $115 puts on Apple. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool has a disclosure policy.