Call and Put Options: What are they, and what do they do?
Random man at a social gathering — “Yeah, I bought a call option for the Tesla stock.”
You in the background — “The f*ck is a call option?”
Buying and selling stocks can be easy. You want to buy a stock, so you buy it, and you want to sell a stock, so you sell it. Simple, right?
But what if you wanted to buy a stock at a discount down the road or sell a stock for a higher cost than its current trading price? That is where call and put options come in. Let me explain.
Call Option
It is a contract that allows you to buy a stock at a set price down the road, typically lower than you think the stock will rise to.
This contract can be completed at any time but does not have to be completed. You can let it expire, but you must pay a fee (called a premium) for it either way.
For Example:
Let’s say you think Apple shares will increase in price. Right now, they’re trading at $90 a share. You can purchase a call option that says you will buy an Apple share for $100 in three months. (Times vary I'm just using three months for this example)
Remember, you’re doing this because you believe that the price is going to go up more than $100 a share. So, you buy this call option for $10.
Scenario 1:
In three months, Apple shares go up in price and are trading at $130 a share. You decided to complete your call option and buy a share of Apple for $100, then sell it for $130. (you do not have to sell this is just to help explain the math)
You spent $100 to buy the share and $10 for the call option, for a total of $110. You then sold that Apple share for $130, making a profit of $20.
Great! Your call option was worth it.
Scenario 2:
In three months’ time, apple shares went down and are now trading at $85 a share. You decided to let the contract expire because you're not about to pay $100 for an $85 share.
In this scenario, you only spent $10 for the contract, which means you lost 10$.
This example was just with one share, and a loss of $10 isn’t a crazy amount. But let’s say you bought a call option contract for 100 shares of Apple. With a price tag of $10 a share, that call option contract will cost you $1,000. Big difference then.
Put Option
It is the opposite of a call option. A put option lets you sell a stock at a specific price down the road. Typically, a higher price than you think the stock will fall to.
Just like the call option, you can complete this contract at any time, but it does not have to be completed. You can let it expire. Just like a call option, it also has a fee called a priemum.
For Example:
You believe Apple shares will fall in price in the next three months. You purchase a share of Apple for its current trading price of $100 a share. You then purchase a put option that says you can sell the Apple share for $90 three months from now. The cost for this put option is $10.
So far, you have spent $110 and own one Apple share ($100 for the Apple share and $10 for the put option). You are doing this because you believe Apple shares will go down in value.
Scenario 1:
Three months from now, Apple shares have fallen in value and are now trading at $60 a share.
You sell your Apple share for $90. At this point, you are in the hole by $20 ($110 — $90), and you no longer own a share of Apple.
Now, you re-purchase the Apple share for its current trading price of $60. You now have your Apple share again and have made a profit of $30. ($90 — $60 = $30)
You were in the hole by $20 but just made $30, leaving you with a net profit of $10. (30–20 = 10)
A little complicated I know, it toke me a solid twenty minutes and some math to comprehend what was going on. Now these numbers are not very realistic I just wanted to keep the number easy to follow.
Scenario 2:
Three months from now, Apple shares have gone up in value and are now trading at $105 a share.
You let the put contract expire because you're not about to sell your Apple share for 90$ when it's trading at $105. In this scenario, you are out the 10$ premium for the contract but still own a share of Apple.
Real-Lime Examples of options available with Wealth Simple:
- Call option for AAPL (apple), currently trading at $192.32:
Call to buy AAPL one month from now for $190 for a premium of $6.58. AAPL will have to rise to $196.58 for me to break even.
2. Put option for AAPL, currently trading at $192.32:
Put to sell AAPL one month from now at $195 for a premium of $5.68. My break-even point would be $189.32.
*Edited*
The need for 100 shares
When purchasing a call or put option, you need to buy the contract for 100 shares. I have yet to find a place that allows you to buy options for just a few shares. Because of this, it keeps most new investors, including myself, from buying options.
*Edited*
How to Remember Call vs Put:
Call option: You call the pizza place to buy the pizza
Put option: You put an ad up to sell something.
Key Things to Remember:
- Call options let you buy a share at a set price within a set time
- Put options let you sell a share at a set price within a set time.
- Both call and put options cost money (called a premium).
- Both call and put options can be completed at any time.
- Call and put options can go to expiry if you want them to.
Next week's topic: Straddles
Probably anyway… I still have to learn how they work.
Hope you enjoyed reading and learned a little something.
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This article is my own opinion and should not be taken as financial advice. Everything I’ve written is for educational purposes only.
