Ever find yourself scratching your head over the terms “calls” and “puts” in the world of options trading? This article is your guide for a straightforward understanding of call and put options.
Call and put options, common derivatives, provide buyers with rights without the obligation to buy or sell an underlying asset at a specific price within a specified date range. Let’s dive into the basics of call and put options to unravel their complexities.
When an investor anticipates an increase in the underlying asset’s price, they can either buy a call option or sell a put option. Conversely, if they expect a decrease, buying a put option or selling a call option might be the strategy.
What Is a Call Option?
A call option grants the buyer the right to purchase a specific security at a predetermined price. The contract includes an expiration date, and buyers are not obligated to execute the purchase.
How Do Call Options Work?
Call options involve a contract between a buyer and a seller on a securities exchange. The buyer pays a premium to the seller for the right to buy the security at a specified price. The seller receives the premium and carries the obligation to sell if the buyer chooses to execute.
Example of Call Option
Imagine stocks of XYZ Company at Rs. 100 per share. If an investor expects no significant rise beyond Rs. 150, they might sell a call option at that price for a premium. If the stock doesn’t exceed Rs. 150, the investor retains the shares without selling.
What Is a Put Option?
A put option gives the buyer the right to sell the underlying asset at a predetermined strike price. Buyers are not obligated to sell, but sellers must buy the asset when the buyer exercises the option.
How Do Put Options Work?
Put options gain value as the underlying stock decreases in price. They provide a selling position and are often used to hedge against downward moves in a long stock position.
Example of Put Option
If an investor owns 100 shares of ABC Company at Rs. 100 per share, they might buy a put option with a strike price of Rs. 100. This gives them the right to sell the shares at that price, protecting against potential declines.
Basic Terms Relating to Call and Put Options
Difference Between Call Option & Put Option
Call options give buying rights, while put options offer selling rights. Call option buyers expect price increases, and put option buyers anticipate decreases.
How to Calculate Call Option Payoffs?
Call option payoffs depend on the spot price, strike price, and premium paid. Buyers can have unlimited gains, while sellers’ losses are limited to the premium.
How to Calculate Put Option Payoffs?
Put option payoffs hinge on the spot price and premium paid. Buyers profit when the stock decreases, while sellers’ losses are capped at the strike price minus the premium.
Risk vs. Reward — Call Option and Put Option
Comparing risks and rewards for call and put options reveals differences in profit potential and loss limitations.
What Happens to Call Options on Expiry?
Call options can be in the money (profitable), out of the money (loss), or at the money (break-even) based on the market price compared to the strike price.
What Happens to Put Options on Expiry?
Put options can be in the money (gain), out of the money (loss), or at the money (loss of premium) upon expiry. Understanding these dynamics is crucial for effective options trading.
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*** Disclaimer: The information provided in this article is for educational purposes only. It is not intended as financial advice, and readers are encouraged to seek professional guidance before making any investment decisions.
