The distinction between call options and put options is one of the first things to grasp if you want to get involved in options trading. Investors always use these words, so it’s essential to understand them.
A call option allows you the right to buy a stock at a specific price by a certain date. A put option allows you the right to sell a stock at a particular price by a specific date.
That’s a quick explanation of these options contracts. Now that you understand the basics, let’s look at how call options and put options operate and the dangers involved with options trading.
How does a call option work?
A call option is a contract linked to a stock. You must pay a premium for the contract. That allows you to purchase the stock at a specific price, called the strike price, until the contract’s expiration date.
You’re not required to do so. If the stock’s price rises high enough, you can execute the option or sell the contract for a profit. If it doesn’t, you may just let the contract expire and only lose the premium you paid.
A call option’s breakeven point equals the strike price plus the premium. With a call option, you can compute your profit or loss at any time by subtracting the current value from the breakeven point.
Need an example?
Let’s assume you’re optimistic about Apple (NASDAQ:AAPL), and it’s trading at $150 per share. You purchase a call option with a strike price of $170 and an expiration date six months from now. The premium is $15 per share, for a total cost of $1,500 (since contracts cover 100 shares.)
Since you add the $170 strike price to the $15 premium, the breakeven point would be $185.
Let’s assume that Apple reaches a price of $195 per share. Your profit would be $10 per share if it reached this price, for a total of $1,000. If the stock drops to $175, you’ll lose $10 per share. The maximum potential loss would be $1500, which you paid for the premium.
How does a put option work?
A put option is a contract linked to a stock that gives the buyer the right to sell it at a specific price. The buyer pays a premium for the contract, allowing you to sell the stock at the strike price. They may exercise their options at any time until they expire.
You may sell your put option for a profit if the stock’s price drops far enough. However, you are not required to execute the contract, so you can let it expire if the asset’s price does not drop enough.
The breakeven point of a put option is the difference between the strike price and the premium. You can calculate your gain or loss at any moment by subtracting the breakeven point from the current price.
Consider a stock you’re thinking about buying. Let’s assume that Netflix (NASDAQ:NFLX) costs $500 per share. You believe it is overpriced, so you purchase a put option with a strike price of $450 and an expiration date three months away for a $10 premium per share. Therefore, the contract has a total cost of $1,000.
The breakeven point is $440, the difference between the $450 strike price and the $10 premium. So you’d be up $40 per share ($4,000 total) on your put option if Netflix plummets to $400. If it doesn’t fall below $450, you’d have to let the option expire and pay for the premium.
Risks of call vs. put options
Buying both call and put options have a disadvantage: they might expire worthless if the stock does not reach the breakeven point. In that case, you’ll lose the premium you paid.
It’s also feasible to sell call and put options, which means you may collect a premium for an options contract from someone else. However, because it entails more risk, selling calls and puts is considerably more dangerous than purchasing them. You’re responsible if the stock price surpasses the breakeven mark. You are also liable if the buyer executes the option, thus fulfilling the contract.
The advantage of buying options is knowing exactly how much money you could lose. This makes options a more secure form of leveraged investment than futures contracts.
On the other hand, options can be riskier than simply buying and selling equities since you have a higher chance of losing your money. When it comes to stocks, all you have to do is predict whether the stock will rise or fall. For options trading, you must correctly predict three things:
- What direction will the stock move?
- How much will the stock move?
- In what period will the stock move?
If you’re wrong about any of them, the options contract will be meaningless. While option contracts have a greater potential for profits, they are also more difficult to trade successfully.
Despite the difficulties of trading put and call options, they can help you boost your profits. In addition, they might be an excellent complement to a well-balanced portfolio. There are also more complex methods for investors interested in options beyond purchasing calls and puts.
A Call option gives the right (but not the obligation) to buy a set number of shares of stock at a predetermined ‘strike price’ before the option expires. An investor purchases a call option in the hopes that the underlying stock price will rise significantly above the strike price, at which point you have the option to exercise it. Exercising a call option is the monetary equivalent of buying stock and immediately selling at a higher market price.
A put option is a contract that gives the right (but not the obligation) to sell a specific number of shares of stock (which you do not yet own) at a predetermined ‘strike price’ before the option expires. An investor buys a put option hoping the underlying stock’s price will drop significantly below the strike price, allowing you to exercise your right.