Content of the material
- Put option vs. call option: At a glance
- How does a call option work?
- Understand Your Tools
- Reading Options Tables
- Selling a Call
- Call and Put Options
- Expiry and Option Chains
- What Is a Put Option?
- Selling a Put
- Call options vs. put options
- How Call Options Work
- What the Call Buyer Gets
- What the Call Seller Gets
- How to Calculate the Call Option's Cost
- What is a Call Option?
- Understanding the differences between call and put options
- Risks of call vs. put options
- Options Tips
Put option vs. call option: At a glance
Options are contracts between investors that give the holder the right to buy or sell an underlying asset (such as a stock) at a fixed price (also called the strike price) on or before a specific date in the future. You pay a premium to own options and you’re not obligated to use them. But if you sell an option, you have to provide the asset to the holder if and when they use (also called exercise) their option.
Options are bought and sold among institutional and individual investors, brokers/professional traders, and other participants in the market. There are two types of options:
- Put option: Gives the holder the right to sell a number of assets within a specific period of time at a certain price.
- Call option: Gives them the right to buy assets under those same conditions.
You can buy or sell options, depending on what your investing goals are. If you purchase options, the most you can lose is the amount you paid for the premium since you’re not obligated to exercise the option. You risk losing more if you sell options since you’re legally obligated to fulfill the terms of the contract regardless of market value for the underlying assets.
“Options are merely side bets between investors,” says Robert Johnson, professor of finance at Creighton University’s Heider College of Business. “No net wealth is created in the options market. What one party gains, the other party to the contract loses an equal and opposite amount.”
How does a call option work?
A call option is a contract tied to a stock. You pay a fee, called a premium, for the contract. That gives you the right to buy the stock at a set price, known as the strike price, at any point until the contract’s expiration date.
You’re not obligated to execute the option. If the price of the stock increases enough, then you can execute it or sell the contract itself for a profit. If it doesn’t, then you can let the contract expire and only lose the premium you paid.
The breakeven point on a call option is the sum of the strike price and the premium. When you have a call option, you can calculate your profit or loss at any point by subtracting the current price from the breakeven point. There’s also a calculator you can use at the bottom of this page.
As an example, let’s say that you’re bullish on Apple (NASDAQ:AAPL) and it’s trading at $150 per share. You buy a call option with a strike price of $170 and an expiration date six months from now. The call option costs you a premium of $15 per share. Since options contracts cover 100 shares, the total cost would be $1,500.
The breakeven point would be $185 since that’s the sum of the $170 strike price and the $15 premium. If Apple reaches a price of $195, your profit would be $10 per share, which is $1,000 total. If it only goes to $175, you’d have a loss of $10 per share. Your maximum potential loss would be the $1,500 you paid for the premium.
Understand Your Tools
Puts and calls can be a useful tool for investors and traders. They can offer protection, leverage and a possibility for a higher profit. They can also be dangerous when they are not used properly.
It’s critical to understand how options contracts affect the risk of a whole portfolio. Learn more through Benzinga, and be sure to check out the educational tools available from your brokerage.
Reading Options Tables
More and more traders are finding option data through online sources. Though each source has its own format for presenting the data, the key components generally include the following variables:
- Volume (VLM) simply tells you how many contracts of a particular option were traded during the latest session.
- The "bid" price is the latest price level at which a market participant wishes to buy a particular option.
- The "ask" price is the latest price offered by a market participant to sell a particular option.
- Implied Bid Volatility (IMPL BID VOL) can be thought of as the future uncertainty of price direction and speed. This value is calculated by an option-pricing model such as the Black-Scholes model and represents the level of expected future volatility based on the current price of the option.
- An Open Interest (OPTN OP) number indicates the total number of contracts of a particular option that have been opened. Open interest decreases as open trades are closed.
- Delta can be thought of as a probability. For instance, a 30-delta option has roughly a 30% chance of expiring in the money. Delta also measures the option's sensitivity to immediate price changes in the underlying. The price of a 30-delta option will change by 30 cents if the underlying security changes its price by $1.
- Gamma is the speed the option for moving in or out of the money. Gamma can also be thought of as the movement of the delta.
- Vega is a Greek value that indicates the amount by which the price of the option would be expected to change based on a one-point change in implied volatility.
- Theta is the Greek value that indicates how much value an option will lose with the passage of one day's time.
- The "strike price" is the price at which the buyer of the option can buy or sell the underlying security if they choose to exercise the option.
Buying at the bid and selling at the ask is how market makers make their living.
Selling a Call
In most cases you must own 100 shares of the stock for each contract you sell – this is called a covered call. Therefore, if your stock gets called away, you have the 100 shares in your account.
You can sell covered calls to generate a stream of income. If the stock price does not rise enough during the period of the contract, you won’t get called and won’t have to sell the stock so you keep the money you received when you sold the call.
If your broker lets you, you may sell “uncovered “or “naked” calls in a margin account. This practice lets you sell calls when you don’t own the stock. If you get called, you must buy the stock at its current market value to cover the call even when the market price is higher than the strike price of the option. Like any margin account transaction, you must execute the transaction immediately.
Call and Put Options
Options are a type of derivative security. An option is a derivative because its price is intrinsically linked to the price of something else. If you buy an options contract, it grants you the right but not the obligation to buy or sell an underlying asset at a set price on or before a certain date.
Expiry and Option Chains
There are two types of expirations for options. The European style cannot be exercised until the expiration date, while the American style can be exercised at any time.
The price of both call options and put options are listed in a chain sheet (see example below), which shows the price, volume, and interest for each strike price and expiration date.
What Is a Put Option?
Conversely, if an investor purchases a put option, they have the right to sell a stock at a specific price up until an expiration date. The investor who bought the put option has the right to sell the stock to the writer for their agreed-upon price until the time frame ends. However, the investor is not obligated to do so.
Purchasing a put option is a way to hedge against the drop in the share price. So, even if the stock price declines on a put option, they can avoid further loss. The investor could also profit from a bear market or dips in the prices of the stocks.
Selling a Put
The seller of a put collects the purchase price of the option from the buyer of the put. The seller has the obligation to buy 100 shares at the strike price regardless of the market value of the underlying stock. So if the put buyer decides to exercise the put contract, the seller of the put has to buy the 100 shares at the strike price no matter the current market value of the stock.
For example, the buyer of a put with a strike price of $50 decides to exercise the option, which means he sells 100 shares of the stock at the strike price to the put seller. The put seller must pay $50 per share even though the market value is, for example, $40. When you sell a put, you want the price of the stock to go up so you don’t get the stock put to you – buy the stock for more than it’s worth.
Selling a put places the money you receive in a margin account so you pay interest on the proceeds until the put contract is closed. If you don’t have the financial resources to cover the obligation of buying the stock from the buyer of the put, you sold “naked puts”.
Call options vs. put options
The other major kind of option is called a put option, and its value increases as the stock price goes down. So traders can wager on a stock’s decline by buying put options. In this sense, puts act like the opposite of call options, though they have many similar risks and rewards:
- Like buying a call option, buying a put option allows you the opportunity to earn back many times your investment.
- Like buying a call option, the risk of buying a put option is that you could lose all your investment if the put expires worthless.
- Like selling a call option, selling a put option earns a premium, but then the seller takes on all the risks if the stock moves in an unfavorable direction.
- Unlike selling a call option, selling a put option exposes you to capped losses (since a stock cannot fall below $0). Still, you could lose many times more money than the premium received.
For more, see everything you need to know about put options.
How Call Options Work
For U.S.-style options, a call is an options contract that gives the buyer the right to buy the underlying asset at a set price at any time up to the expiration date.
Buyers of European-style options may exercise the option— to buy the underlying asset—only on the expiration date. Options expirations vary and can be short-term or long-term.
With call options, the strike price represents the predetermined price at which a call buyer can buy the underlying asset. For example, the buyer of a stock call option with a strike price of $10 can use the option to buy that stock at $10 before the option expires.
It is only worthwhile for the call buyer to exercise their option (and require the call writer/seller to sell them the stock at the strike price) if the current price of the underlying asset is above the strike price. For example, if the stock is trading at $9 on the stock market, it is not worthwhile for the call option buyer to exercise their option to buy the stock at $10, because they can buy it for a lower price on the market.
What the Call Buyer Gets
The call buyer has the right to buy a stock at the strike price for a set amount of time. For that right, they pay a premium. If the price of the underlying asset moves above the strike price, the option will have intrinsic value. The buyer can sell the option for a profit, which is what many call buyers do, or they can exercise the option (i.e., receive the shares from the person who wrote the option).
What the Call Seller Gets
The call writer/seller receives the premium. Writing call options is a way to generate income. However, the income from writing a call option is limited to the premium. A call buyer, in theory, has unlimited profit potential.
How to Calculate the Call Option's Cost
One stock call option contract represents 100 shares of the underlying stock. Stock call prices are typically quoted per share. To calculate how much it will cost you to buy a contract, take the price of the option and multiply it by 100.
Call options can be in, at, or out of the money:
- "In the money" means that the underlying asset price is above the call strike price.
- "Out of the money" means that the underlying price is below the strike price.
- "At the money" means that the underlying price and the strike price are the same.
You can buy a call in any of those three phases. However, you will pay a larger premium for an option that isin the money, because it already has intrinsic value.
What is a Call Option?
A purchase of a call option gets you the right to buy the underlying at the strike price. Instead of owning a stock, you can buy a call option and participate in a potential upside.
Your potential loss is limited to the paid premium and you get unlimited upside potential. If you want to buy the July 6, 190 strike call in Apple, you would have to pay around $2.80 and you would profit if the stock trades above $192.80 at the July 6 expiration.
If Apple closes at $200 on July 6, you exercise the call and buy the stock at $190. Your net price would be $192.80, but you could sell it immediately for $200 and make $7.20 per share. You could choose a different strategy and trade the call you bought before the expiration.
Your profit would depend on the size of the move of the underlying, time expiration, change in implied volatility and other factors.
Just like the put, you can sell calls and generate income. If the price moves against you, you would have to sell the stock to the buyer of a call. If you don’t already own it, you would have to borrow shares and take a short position.
Another popular strategy using calls is a covered call strategy. In this strategy, you own the stock and you sell a call against it. Your selling price is fixed or limited to the sum of the strike of the call and a premium collected, but on the other hand, the premium provides you protection.
Understanding the differences between call and put options
As you can see, call and put options represent very different trading instruments. Whereas investors buy call options when they expect a stock to rise, they’ll sell put options when they anticipate a stock to fall. If you want to hedge your portfolio against loss, options can be a viable option, although it’s also worth remembering that call and put options will always have an element of risk. However, if you’re happy to accept those risks, you may be able to reap substantial rewards.
Options are high-risk, high-reward when compared to buying the underlying security. Options become entirely worthless after they expire. Also, if the price does not move in the direction the investor hopes, in which case she gains nothing by exercising the options. When buying stocks, the risk of the entire investment amount getting wiped out is usually quite low. On the other hand, options yield very high returns if the price moves drastically in the direction that the investor hopes. The spreadsheet in the example below will help make this clear.
Risks of call vs. put options
The risk of buying both call and put options is that they expire worthless because the stock doesn’t reach the breakeven point. In that case, you lose the amount you paid for the premium.
It’s also possible to sell call and put options, which means another party would pay you a premium for an options contract. Selling calls and puts is much riskier than buying them because it carries greater potential losses. If the stock price passes the breakeven point and the buyer executes the option, then you’re responsible for fulfilling the contract.
The benefit of buying options is that you know from the beginning the maximum amount you can lose. This makes options safer than other types of leveraged instruments such as futures contracts.
However, options can be riskier than simply buying and selling stocks because there’s a greater possibility of coming away with nothing. When investing in stocks, you only need to predict whether the stock goes up or down. For options trading, you need to predict three things correctly:
- The direction the stock will move.
- The amount the stock will move.
- The time period of the stock movement.
If you’re wrong about any of those, then the options contract will be worthless. While there’s the potential for greater returns with options, they’re also harder to trade successfully.
Despite the challenge of successfully trading call and put options, they provide an opportunity to amplify your returns. That can make them a valuable addition to a balanced portfolio. For investors interested in options, there are also more advanced strategies that go beyond buying calls and puts.
Want to quickly see how much an options contract is worth? You can use the calculator below to determine the current value of a call or put option.
* Calculator is for estimation purposes only and is not financial planning or advice. As with any tool, it is only as accurate as the assumptions it makes and the data it has, and it should not be relied on as a substitute for a financial advisor or a tax professional.
- A financial advisor can help you put an investing plan into action. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Do you know what kind of investment risk you can tolerate? What will your investment look like years from now? How much will taxes and inflation take out of your investment? SmartAsset’s investing guide can help answer some of these initial questions.
Photo credit: ©iStock.com/wutwhanfoto, ©iStock.com/wichayada suwanachun, ©iStock.com/Cecilie_Arcurs