Are Puts riskier than Calls?

Taking risks with puts and calls

The short answer is NO. Puts are not riskier than calls. This is also true for the opposite. Calls are not riskier than puts either. The long answer is, it’s way more complicated than picking a yes or no. It depends on a few factors and that is usually the case with options a lot of times.

Options are almost always fairly priced. The price you see at the moment is the fair value for it. If you see an option not fairly priced, there is no way you can take advantage of it as a retail trader. Algorithmic trading by big institutions will make that disappear before you can even decide how to take advantage of it.

Why do people ask this?

If you are looking at the options prices in an index, you will notice that the puts cost more than the calls. For example, I am looking at a SPY option with a strike that is $10 out of the money and compare it against a call that is $10 out of the money. SPY is around $415 so I am going to look at the $405 put and the $425 call.

$405 put cost $792 while the $425 call cost $480. That is a difference of $312. I am looking at SPY options that expire in the July cycle which is 54 days away.

Both of them are about $10 away from the stock price. The chances of stock moving up or down $10 should be somewhat the same. If the probability of the stock reaching $405 or $425 is the same, then the risk is the same….. but if the risk is the same then why does the put cost $312 more than the call?

Why are puts more expensive than calls?

The basic supply and demand model is in action when it comes to options pricing. Most portfolios are usually buy and hold portfolios. So the “cheapest” way to protect a portfolio from an unforeseeable market crash is to buy a put. So looking at the SPY example from above, you can say more people are buying the $405 puts compared to the $425 calls so they can get better sleep at night, then that naturally pushes up the prices of puts making them more expensive than calls.

The old adage of the market takes the stairs up and the elevator down plays a role in this. Nobody really knows when the market is going to crash but when it does, it usually happens very quickly. 

Whenever I look at my brokerage account, I am hoping for a sea of green with all the stocks I own going up. I don’t look at how much it has gone by. As long as it’s moving up, I am making money and my portfolio is doing better. It’s usually a tiny percentage and it’s grinding up slowly. But when there is a red day, I am looking at how much it’s down by and the panic sets in after depending on how bad of a day it is.

I have a small portfolio and I panic even though I am fairly confident that the stocks I own will eventually come back up. Now let’s imagine a professional money manager who has to answer to investors. Does paying up for puts seem all that bad if your job is potentially on the line?

Are puts always more expensive than calls?

I picked SPY and mentioned Index earlier on purpose. I looked at options 60 days out and almost 1000 days out and I couldn’t find an option cycle when calls are more expensive. I can’t think of a time I remember seeing calls being more expensive in the Index. So while Puts are usually more expensive in every underlying, that is not always the case. I can think of 2 scenarios where the calls are more expensive than puts.

1. Melt up in a stock

This is usually for whatever stock or industry is the talk of the town at the moment. This happened with Tesla in 2019. GameStop in Feb 2021. Almost all SPACs at the end of 2020 and beginning of 2021. Tilray in 2018 pretty much after they went public.

A melt up is when there is a sudden big up move in a stock and it keeps doing that for a few days where that’s the only stock people talk about. That’s when everyone is running to buy far out of the money calls like the $800 strikes in GME because any strike remotely close to the stock price is way too expensive for anyone to afford. The allure of great riches you see on Reddit and full-blown FOMO gives you the impression that you can still mint money with those far out of the money calls.

These are risky as hell because the big move has already happened and you are looking at very expensive calls when people are trying to lock in their profits and get out of the stock. You are going to be left holding the bag in that scenario.

I don’t have any great examples like the GME one right now. I don’t have a stock that is exactly melting up either. However, I have Roblox that has gone up by almost 20% in 3 days and the calls are more expensive.

Roblox (RBLX) closed at $82.50 on Friday and I am looking at the $75 strike put that is $7.5 out of the money to the downside and the $90 call that is $7.5 out of the money to the upside. The $90 call cost $585 and the $75 put cost $510. The call cost $75 more than the put even though it’s equally far away from the stock.

A 20% up move in the stock in the last 3 days has made everyone more hopeful that it will continue going up so why not get on this before it’s too late. This is driving more demands for the $90 calls compared to the $75 puts. I consider this very speculative and basically gambling. This is a scenario where there is more risk to the upside and you could argue that calls are riskier than puts in this case.

2. Options far into the future in individual stocks

This would be like a regular investment in my opinion. I am going to look at Facebook as an example.

Facebook is trading around $316 right now and I am looking at options that expire in June 2023. The $310 put which is $6 out of the money is priced at $5895 while the $325 call that is $9  out of the money is trading for $6320. The call is much further out of the money compared to the put I have chosen but it’s priced higher.

Since the stock market usually goes up over time it only makes sense that calls cost more because they have a higher likelihood of being in the money and that’s where you are going to see demand.

At the same If you are to look at options in the index like SPY, QQQ or IWM, those will still have the puts priced higher because they are going to be used as insurance against the calls like Facebook above.

Conclusion

There is a lot more information when it comes to how options are priced. But the question of whether puts are riskier than calls isn’t something that you should really consider as a blanket statement. There is no one answer that completely satisfies this question. 

This really plays into the statement of high-risk high reward low-risk low reward. You can generally look at it as if puts are more expensive, that’s where the risk is perceived to be by the market at that moment and that typically means that’s the direction you can find a higher reward.

Even then you will only enjoy this reward if the stock moves in the direction you want whether it’s a put or a call. When I see a “pricey” put, I’m not thinking it’s riskier. I’m thinking there’s more demand for these puts because people are trying to hedge their long portfolios. And that’s just the cost of doing business.

How to make money with options

Money in an Envelope

People usually look into options trading because they think it’s a means of getting rich quickly. Yes, there are instances where some have definitely made an enormous amount of money very quickly but the truth of the matter is very few have done that and most have lost money.

This is more of my opinion on how someone should start with options or better yet now that I know better if I could have a redo then this is how I would start with options. This is not a get rich quick method at all. This would probably fetch you between 5% – 20% a year if everything goes well.

So with my redo, I would start with something simple and straightforward. Selling a put would be the easiest to start and it’s also something that could be understood because it’s the closest thing to buying stock directly.

Before getting into the details too much, there are definitely some requirements that needs to be taken care of

  • Understand what options are
  • Money
  • Brokerage account
  • Small list of companies that you’re willing to buy
  • Understanding your risks with selling a put

The order I have listed above is not perfect, it’s what made sense to me. The important matter  is that you understand what all of it is and know the risks you are taking on.

Understanding what options are

Since this is a write-up about options and how to start with options, it’s quite important that you know what options are and I have a write-up on this that I did a while ago that you can find here. If you’re short on time the part that you want to look out for is selling put options.

Money

You already know this, you need to have some money if you want to start investing. Better question is how much money? Starting off with options $5,000 seems like a decent number for a beginner. It goes without saying the more you have, the better. More money gives you a lot more flexibility.

Brokerage account

If you are already investing then this is not really a concern. Most likely, the platform that you’re on already has options capability.

If you are looking for one, Thinkorswim by TD Ameritrade seems to be the most popular platform from what I’ve read. I have not used them so I can’t be sure. 

I started investing in 2016 on Robinhood and i think my first options trade was on Robinhood in June 2018 and I have continued using them.

If you’re signing up for a new account, you should look for commission costs and check if they have any promotion so you can get some freebies while you’re at it.

And a word of caution some of the brokerages have a tendency of saying commissions are $0 per trade but they usually have something written in smaller font that says it’s $0.65 per contract so it’s not exactly zero dollars per trade for options.

Small list of companies that you’re willing to buy

You’ll be creating a watchlist of companies that you’re interested in buying. The rule of thumb that I would use if you’re starting with $5,000 would be to find companies that are $25 per share and below. You can scale this up based on how much you’re starting off with. If you have $10,000 then $50 per share.

I’ve used finviz screener to come up with my watchlist because they have a filter for price that gives you under $10, under $20 etc. It doesn’t have an under $25 in the dropdown menu but you can fiddle around and create a watchlist with a few companies to your liking.

How did I come up with $25 per share as the threshold for a $5,000 account? it’s what I’m comfortable with. More on this below.

Technically the smaller the better so the $25 is just a guideline of what your upper limit should be.

Understanding your risks

If you read the post on what are options? and particularly the selling put options portion then you know if you’re using the $25 upper limit that I suggested earlier then that means that every time you sell a put, you’re allocating close to $2,500 as collateral (because each options contract is 100 shares).

This is also the reason why I said if your starting amount is $5,000 you want your stocks to have an upper limit of $25 because with each trade you’re probably risking half your money.


Now if you’ve done all these steps –  good. you can start and this is what you’re trying to do.

You are going to take on the role of an insurance company. This is the best comparison that I could come up with.

Using car insurance as an example – you pay your premiums and the car insurance company provides you with coverage if you get into a fender bender.

By selling a put, you are the car insurance company. You will get the premium the moment you sell the put option and you will have to cover the costs if the buyer gets into a fender bender. Fender bender in this case would be the stock you sold the put on is below the price you picked.

The steps are as follows.

Pick the Stock

Most of the hard work for picking the stock has been done already with the creation of the watchlist. From the watchlist, pick the stock that’s having the worst day.

Pick an expiration

I typically like to pick an expiration date that is 30-60 days out into the future preferably the third Friday of the month. Third Friday is the monthly expiration, those contracts are the ones that are most sought after and the ones that people are usually looking to buy or sell. If you pick an expiration date less than 30 days, most likely you won’t be able to sell the put option for a price that is worth the risk you are taking on. This could vary a lot depending on the stock.

Pick the strike price you want to sell

Time to put on the bargain hunting hat and decide what discount you would like for the stock. A 10%-15% discount seems nice to me. so if it’s a $25 stock you want to look for a strike that is $22.5 or a bit lower. You can change this to your risk profile. The closer you are to the current stock price, the more risk you’re taking on and you get paid accordingly.

Collect premium

This is the car insurance portion where you want to get the premium or monthly payment or whatever you want to call it. I look for about 1% – 2% premium for the money that I have to set aside as collateral. If I’m using the $22.5 strike, then I’m committing $2,250 towards this investment. The premium I would like to get for this risk is about $45.

Premium is just the amount I get for selling the put option. 1% – 2% is just a number that I look for. Depending on how much risk you’re willing to take you can play around with this number. Stocks that’s considered risky will have more premium than the less risky ones. 

So let me put this all together with the real stock to see what it looks like.

Step 1. Pick a stock –  I’m going to pick a Rocket Mortgage RKT for the purposes of this illustration.

Step 2. Pick an expiration –  I am looking for the next third Friday which is February 19th, 2021. This fits the guideline of at least 30 days into the future.

Step 3. Pick strike price –  Stock is trading around $20 a share right now. I want the 10%-15% discount, I am going to play it safe and select the $17 strike put for my put options which is about a 15% discount.

Step 4. Collect Premium –  $17 strike put is selling for around $55 which is a bit above 3%. Much higher than the 1% – 2% that I am usually looking for, so I am open to selling this put.

The mindset that I’m going to have here is that Rocket Mortgage is trading about $20 per share right now and I’m interested in buying the stock just not at the current price. However I’m willing to buy 100 shares of it at $17 by Feb 19th 2020. And getting $55 while waiting is not bad at all.

The best thing that can happen is Rocket Mortgage RKT stock price doesn’t go anywhere close to $17 and stays above the $17 per share price from now till February 19th 2021. If that’s to happen then I get to keep the $55 that I got initially and I move on.

The worst thing that can happen is Rocket Mortgage RKT stock price is below $17 by Feb 19th and it gets progressively worse the further away it is from the $17 strike price. For whatever reason, let’s say it’s trading at $10 by Feb 19th then I am forced to buy rocket mortgage at $17 a share but now since the stock is trading at $10 it’s only worth $1,000 for the 100 shares which is going to look like a loss of $700 but I guess I can feel okay about it because at least I have the shares now. I will probably have to hold on to them until the price recovers. This is also the reason why you want to only sell puts on stocks that you are willing to own. Do this enough number of times over and over and this is bound to happen at some point.

Let’s imagine that you are able to do this over and over for a year and are never in a position where you are forced to buy the shares, then this will make $55 about six to seven times a year which amounts to $330 on the $1700 you set aside as collateral. That’s about a shade under 20% return in a year which is really great.

One question that’s left over from all of this would be why should you have $5000 in your account if you are only planning to use only $2500 on each trade. That’s just leftover money to use whenever a great opportunity comes along. You never know when a great opportunity will come along and whenever it does you want to have the funds to do something about it. This cash reserve is also called dry powder. 

Conclusion

For folks starting with options, this is going to be a bit cumbersome and it will take some time to get used to these steps. After a few iterations it will come more naturally.

This step by step cheat sheet of sorts would come in handy for people who are looking to buy specific stocks.  

A few things to remember are pick companies you want to own, define the risk you are comfortable with and only sell puts for prices that you think are worth the risk you are taking. 

Bonus tip:

Once you sell and you want to sound like a know-it-all then here two things you could say. I am going to use the Rocket Mortgage RKT example again.

  1. You could say you are short the $17 strike put – It means you sold the $17 strike put.
  2. You could say you are long RKT – it means you want RKT to go up in price.

What are options?

Raining Money

Options are financial contracts that give the buyer the right and not the obligation to buy or sell a stock at a specific price by a certain date.

The seller has the obligation to buy or sell the stock at that specific price if the buyer wants to at that specific price.

This all sounds very formal and I am sure that definition is a modified version of something I read in the past. 

This is a pretty straightforward concept or at least it’s supposed to be straight forward but anytime I’ve read about it, it’s just complicated. Options are flexible and people use it for different purposes and I think trying to explain all of that makes it complex for anyone let alone a beginner. The flexibility that comes with options makes it a very vast topic and jumping into them with a lot of money in the beginning can quickly spiral out of control leading you to lose all of your money. Here, I will try to explain the very basics (just scratching the surface) of options but before we get into them, there are a few terms that you have to know.

  1. Strike price

It’s a contract so two people have to agree on what price the shares are going to be bought or sold. That’s the strike price.

  1. Expiration

This contract is only valid for a certain amount of time. That’s the expiration date. Another way to think about it is like your car insurance where you pay your premium for 6 months and you get coverage for those six months. Once those six months are over and if you don’t pay again then you don’t have insurance. Your coverage is over. your contract has expired.

Popular stocks that trade very often and are household names have contracts that expire every Friday for the most part and the rest of them have one expiration each month which is on the third Friday of every month.

  1. Premium

Using the car insurance example, you pay a premium to have the insurance. Similar to that, a buyer has to pay a premium to have the opportunity to buy or sell the stock at the strike price. This applies to anyone buying an option.

  1. Collateral

if you get into a car accident your insurance company covers the cost because of the insurance contract you have. The money that is set aside by insurance companies to pay for those damages is the collateral. Depending on the kind of option, the collateral can be money or stock. This applies to anyone selling an option. It is also called buying power reduction if you are using a margin account.

  1. Option size

This is not a definition per se. This is more of a need to know. Each option contact is for 100 shares. 

There are two types of options

  1. Call
  2. Put

There are two parties involved

  1. Buyer
  2. Seller

Combining all of these different variables seems very daunting but those give you the flexibility of making a directional bet easily. 

As a beginner to options this is how I look at it. The risk is different depending on what combination you go with.

If you think a stock will go up then you can either buy a call or sell a put. The amount of money you can make will be vastly different and the way you would set up the options contract would be different. Buying a call would cost you very little upfront and the amount you can make from is astronomical if the stock skyrockets. Selling a put would require you to keep a significant chunk of money as collateral and the maximum profit would be whatever you collected initially as premium when you sold the put option.

So how does this work and what would it look like

Buying call options

XYZ company is trading at $50 a share right now and you think the stock is going to move up to $70 a share in two weeks. 

You might consider buying the $60 strike call option that expires a month away for $1.00. This will cost you $100 because each option contract is for 100 shares. This is the premium.

If your assumption comes true then you stand to make $9 per share ($900 because a contract is 100 shares) 

The calculation works out to be $70 per share which is the stock price at expiration minus $60 per share which is your strike price and then minus the $1 per share you paid in premium.

This would be a 900% return because you made $900 using $100. The same move in the stock will get you a return of 40% where you would make $2,000 in profits on the initial $5,000 spent to buy the stock.

$70 – $60 – $1 = $9 

Stock price at expiration – Strike price – Premium Paid = Profit

This is great when everything works out the way you want but what if the stock price stays at 50 and does not move at all then the call would expire worthless and you would lose the $100 you paid initially as premium.

When and why would you do this?

  • Amplified returns.
  • You are convinced the stock will move up dramatically in a certain time frame. Especially handy for small biotech companies that sees a big stock price jump after getting FDA approval.
  • You are willing to lose the premium if the stock move you are hoping for doesn’t pan out.
  • More Misses than hits.
  • YOLO move – you only live once or you really lose once depending on how you look at it.

Selling put options

All the assumptions for XYZ company stays the same, XYZ company is trading at $50 a share and you think it will go up to $70 in two weeks

You might consider selling the $30 Strike put option for a month out for $1.00 ($100 since the contract represents 100 shares). This will cost you $3000 in collateral.

If they stock moves up to $70 a share in a month then the contract expires worthless and you will keep the $100 in premium you collected. Well as long as the stock price stays above the $30 strike price at expiration, you will keep the $100 collected initially.

If the stock is below the $30 then you will have to buy the stock at $30 a share since that is the contract you agreed to. This is where the $3000 collateral comes into play. You have already set this money aside when you started this trade.

The calculation works out differently from buying a call, you already know the maximum you can make is $100 as long as the stock price is above $30 a share at expiration.

Your return would be $100 on $3,000 you put down as collateral. This would be 3.33% in one month

When and why would you do this?

  • Consistent returns.
  • It’s a stock you like but you want to buy it at a lower price.
  • You think the stock will move but you are not fully convinced of it.
  • You want to get paid while waiting for the stock to come to a lower price.
  • More hits than misses.
  • Generate an income-based investing or trading.

Now moving to the other side, the scenarios are going to sound very repetitive since it’s just the other side of the same coin.

If you think a stock will go down then you can either buy a put or sell a call. Everything in this portion works in reverse of the items mentioned above. Buying a put will cost you very little upfront and the amount you can make from it is significant if the stock tanks. A key difference here compared to buying a call is that there is a limit to how much you can make because the worst that can happen to a stock is for it to go to $0. Similarly to selling a put, selling a call would require you to keep a significant chunk of money as collateral or 100 shares of the stock and the maximum profit would be whatever you collected initially as premium when you sold the call option.

Buying put options

Buying a put resembles the car insurance analogy I gave earlier except you are hoping for an accident to happen. Pay the premium and get a big payout if things go horribly wrong with the stock. But a less cynical way to look at it is buying a put option to protect stock you already own and in this way the put will behave exactly as having car insurance where you pay your premium just in case something bad happens.

Using the same XYZ company as the example, XYZ company is trading at $50 a share right now and you think it’s going to come down to $30 in two weeks. You can buy a put at a strike price of $40 spending $1 in premium which would be $100 because each contract is one under chairs.

Similar to buying a call, if everything works out you would net $900 profit after spending $100 in premium.

The calculation works out to be $40 per share which is the strike price minus $30 per share which is your stock price at expiration and then minus the $1 per share you paid in premium.

This would be a 900% return because you made $900 using $100.

$40 – $30 – $1 = $9 

Strike price – Stock price at expiration – Premium Paid = Profit

When and why would you do this?

  • Amplified returns.
  • You are convinced the stock will move down dramatically in a certain time frame.
  • A cheap way to protect stock you already own.
  • You are willing to lose the premium if the stock move you are hoping for doesn’t pan out.
  • More Misses than hits.

Selling call options

We are back to XYZ company and it’s trading at $50 a share and you think it will go down to $30 in two weeks.

You might consider selling the $70 Strike call option for a month out for $1.00 ($100 since the contract represents 100 shares). This collateral is a bit iffy, you can put 100 shares as collateral or it would be an amount that is calculated by your broker if you have a margin account.

If the stock moves down to $30 a share or stays below the $70 strike price in a month then the contract expires worthless and you will keep the $100 in premium you collected.

If it doesn’t work out then you sell the shares at the agreed strike price.

When and why would you do this?

  • Consistent returns.
  • Make money on the stocks you already own.

Conclusion

Options are risky but the first step is to understand what options are so you can understand the risks associated with them. Buying options is the easy part where you could potentially make a lot of money but the trade off is you will have more losers than winners. Selling options gives you a cap on maximum returns and statistically have more winners than losers.