Have you heard of put and call options? Investing in the stock market can be a lucrative venture, but it can also be a risky one. To mitigate the risks, investors use various strategies and tools, one of which is options trading.
Options give investors the right, but not the obligation, to buy or sell a stock at a certain price, known as the strike price, on or before a specified date. Put and call options are two types of options that offer investors different ways to profit from the market.
Put and Call Options
In this article, we will delve into the world of put and call options, explore their differences, and discuss how investors can use them to their advantage. Whether you’re a seasoned investor or a beginner, understanding the basics of put and call options can help you make informed investment decisions and potentially boost your returns.
The Meaning of Put and Call Options
A call option is the right to buy a stock at a predetermined price by an expiration date, whereas a put option is the right to sell a stock at a predetermined price by an expiration date.
That was just a short definition of put-and-call options. Now, let’s take an in-depth look at put and call options.
How Does Put Options Work?
A put option is a contract that involves a stock. You pay an amount of money for the contract, which lets you sell the stock at a certain price. You can decide to sell the stock at any time until the contract expires.
If the stock’s price goes down enough, you can sell your put option for more money than you paid for it. You don’t have to sell the stock if you don’t want to. If the stock’s price doesn’t go down enough, you can just let the contract expire.
The breakeven point for a put option is the price difference between the selling price and the amount you paid for the contract. You can figure out your profit or loss by subtracting the breakeven point from the current stock price or by using a calculator.
For example, suppose you think Netflix is too expensive at $500 per share. You buy a put option that lets you sell the stock at $450 per share, three months from now. You pay $10 per share, or $1,000 total, for the contract.
The breakeven point is $440 per share. If Netflix’s price drops to $400 per share, you can sell your put option for $50 per share more than you paid for it, which is a total profit of $4,000. If the stock’s price doesn’t go below $450, you can let the contract expire and just lose the cost of the premium.
How Does Call Option Work
A call option is a contract for a stock. You pay a fee called a premium for the contract, which gives you the right to buy the stock at a set price, known as the strike price, until the expiration date.
You don’t have to buy the stock if you don’t want to. If the stock’s price goes up enough, you can choose to buy it or sell the contract for a profit. If the price doesn’t go up enough, you can just let the contract expire and lose only the premium you paid.
The breakeven point for a call option is the total of the strike price and the premium. You can figure out your profit or loss by subtracting the current stock price from the breakeven point. There’s also a calculator you can use to do this.
For example, let’s say you believe Apple is going to do well, and it’s currently selling at $150 per share. You buy a call option with a $170 strike price and an expiration date six months from now. The option costs $15 per share, or $1,500 in total for the 100-share contract.
The breakeven point is $185 because you add the $170 strike price to the $15 premium. If Apple’s price goes up to $195, you’ll make a profit of $10 per share, which is $1,000 total. If the price only goes up to $175, you’ll lose $10 per share. The most you can lose is the $1,500 you paid for the premium.
Risk of Put and Call options
When buying a call and put options, there’s a risk that they may expire worthless if the stock doesn’t reach the breakeven point, resulting in the loss of the premium paid. On the other hand, selling call and put options can be riskier since you may end up having to fulfill the contract if the buyer executes it. Compared to other leveraged instruments like futures contracts, options are considered safer as the maximum loss is known from the beginning.
However, options are riskier than trading stocks as it requires predicting three things: the direction, amount, and time period of the stock movement. Failure to predict any of these correctly can result in a worthless options contract. Though options offer the potential for higher returns, it can be challenging to trade them successfully.
Despite the challenges, call-and-put options offer an opportunity to increase returns and can be a valuable addition to a balanced portfolio. For those interested in options, there are also more advanced strategies available beyond buying and selling calls and puts.
What are Options?
Options are contracts that give the bearer the right—but not the obligation—to either buy or sell an amount of some underlying asset at a predetermined price at or before the contract expires. Like most other asset classes, options can be purchased with brokerage investment accounts.
How Options Work
The value of an option increases with the likelihood of a price move in the underlying stock and decreases as the expiration date approaches. Options are a wasting asset due to time decay, meaning that a one-month option is worth less than a three-month option with the same strike. Volatility also increases the price of an option as uncertainty raises the odds of an outcome. In most US exchanges, a stock option contract is the option to buy or sell 100 shares.
How to Trade Options
Nowadays, some brokers allow their clients who meet certain qualifications to trade options. To gain access, you will need to get approval from your broker for both margin and options. Once approved, there are four basic things you can do with options:
- Buy (long) calls
- Sell (short) calls
- Buy (long) puts
- Sell (short) puts
If you buy a stock, you have a long position. If you buy a call option, you have the potential for a long position in the underlying stock. If you short-sell a stock, you have a short position. If you sell a naked or uncovered call, you have a potential short position in the underlying stock. If you buy a put option, you have a potential short position in the underlying stock. If you sell a naked or unmarried put, you have a potential long position in the underlying stock. It’s important to keep these four scenarios straight.
Holders And Writers
People who buy options are called holders and those who sell options are called writers of options. Here’s the important difference between holders and writers:
- Call holders and put holders (buyers) are not under obligation to buy or sell. They have the option to exercise their rights. This limits the risk of options buyers to only the premium spent.
- Call writers and put writers (sellers), however, are obligated to buy or sell if the option expires in the money (more on that below). This means that a seller may be required to make good on a promise to buy or sell. It also means that option sellers have exposure to more and in some cases, unlimited risks. This means writers can lose much more than the price of the options premium.
Options can also provide recurring income. Additionally, they are often used for speculative purposes, such as betting on the direction of a stock.
Note that options trading usually comes with trading commissions: typically, a flat per-trade fee plus a smaller amount per contract, for example, $4.95 plus $0.50 per contract.
Frequently Asked Questions
Which Option Is Best Call or Put?
Because the price of a stock cannot be capped, call options have unlimited profit potential. Put options, on the other hand, have limited potential gains because a stock’s price cannot fall below zero.
When Should I Call and Put?
If you want to bet on a rise in volatility, buying a put option is the better option. If you are betting on volatility decreasing, selling the call option is a better option.
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