Introduction
By understanding the difference between call vs put options in options trading, you gain the ability to profit from price movements in stocks, indices, or other assets without owning them directly. This section will introduce you to the key distinctions between call vs put options.
Call vs Put Option
| Parameters | Call Option | Put Option |
|---|---|---|
| Definition | Provides the right to buy an asset at a specified price within a specific time frame, without obligation | Provides the right to sell an asset at a specified price within a specific time frame, without obligation |
| Buyer’s expectations | Expects the price of the underlying asset to increase | Expects the price of the underlying asset to decrease |
| Seller’s expectations | Expects the price of the underlying asset to remain the same or decrease | Expects the price of the underlying asset to remain the same or increase |
| Maximum Profit | Unlimited (if the price of the underlying asset rises significantly) | Limited to the strike price minus the premium paid (if the price of the underlying asset falls to zero) |
| Maximum Loss | Limited to the premium paid (if the price of the underlying asset remains below the strike price) | Limited to the strike price minus the premium paid (if the price of the underlying asset rises significantly) |
| Market Direction | Bullish (benefits from rising prices) | Bearish (benefits from falling prices) |
| Risk-Reward Profile | Higher risk, potentially higher reward | Lower risk, limited reward |
| Example | If you believe that a stock currently priced at $50 is going to rise, you might buy a call option with a strike price of $55. This means you are betting the stock price will exceed $55 before your option expires. | if you anticipate that the same stock will fall, you might purchase a put option with a strike price of $45, expecting that the stock will sink below this level before your option reaches its expiration date. |
Types of Options Contracts
Options contracts can also be categorized based on the duration of the contract.
- European Options: These options can only be exercised at the expiration date.
- American Options: Unlike European options, American options can be exercised at any time before the expiration date.
How do call options work?
To understand the key difference between call and put options, we must first understand how call options work. The process of trading call options can be broken down into several steps:
1. Choose the right call option: Traders start by selecting the asset they believe will increase in price. They then choose a call option with a specific strike price and expiry date that aligns with their predictions and investment strategy.
2. Paying the premium: To initiate a call option, the buyer pays a premium to the seller. This premium is the price of acquiring the option and depends on various factors such as the current price of the asset, the strike price, and the time until expiration.
3. Waiting for price movement: After acquiring the call option, the buyer will monitor the market to see if the asset’s price rises as anticipated. The value of the call option increases as the price of the underlying asset goes up.
4. Deciding to exercise: If the underlying asset’s price exceeds the strike price (this scenario is referred to as being “in the money”), the buyer can exercise the option, purchasing the underlying asset at the strike price. This often results in a profit, as the buyer can now own and potentially sell the asset at the higher market price.
5. To sell or not to sell: Before the expiration date, the holder of the option may also choose to sell the option itself to another Trader to realize early profits from the increase in the option’s premium due to the rise in the asset’s price.
6. Expiration: If the option is not exercised or sold by the expiration date, it expires worthless. The buyer’s loss is then limited to the premium paid for the option.
How do put options work?
Here’s a simple breakdown of how trading put options typically works:
1. Selecting the Put Option: Traders who believe that the price of an asset will decline will look for a put option with a strike price that reflects their prediction and an expiration date that gives the asset time to decrease in value.
2. Paying the premium: The buyer of the put option pays a premium to the seller. This premium grants them the right to sell the underlying asset at the strike price.
3. Price declines: If the underlying asset’s price begins to fall, the value of the put option increases. If the price of the underlying asset drops below the strike price, the option is considered “in the money.”
4. Exercising the option: The holder of a put option can choose to exercise the option, selling the underlying asset at the strike price to the seller of the put. This can be profitable if the market price is less than the strike price.
5. Selling the option: Alternatively, if the holder of the put does not own the underlying asset or chooses not to exercise the option, they can sell the put option itself, which is likely to be more valuable given the decline in the asset’s price.
6. Option expiration: If the put option is not exercised or sold by its expiration date, it will expire worthless. The holder’s loss will be limited to the premium paid for the option.
Basic Terms Relating to Call vs Put Option
We must also understand the terms related to call vs put options:
- Strike Price: This is the price at which the option holder can buy or sell the underlying asset when exercising the option.
- Expiration Date: This is the date by which the option contract expires. After this date, the option is no longer valid.
- Premium: The price paid by the option buyer to the option seller for acquiring the right to buy or sell the underlying asset.
- In-the-money: A call option is in-the-money when the market price of the underlying asset is higher than the strike price. Conversely, a put option is in-the-money when the market price is lower than the strike price.
- Out-of-the-money: This is the term used when the market price of the underlying asset is not favorable for the option holder to exercise the option.
- Writing an option: This refers to selling an option contract to another party. The seller is obligated to fulfill the terms of the contract if the buyer decides to exercise the option.
Conclusion
In a nutshell, the key difference between call and put options is that call options let you bet on prices going up, while put options allow you to profit if prices go down—both without actually owning the asset.
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