Acronyms for call options and put options, calls and puts are derivative investments that give you the right to buy or sell an underlying instrument at a specific price. Before we dig deep into calls, puts, and the differences between them, let’s first understand Options and what separates them from Derivatives. The reason for this is simple: calls and puts are forms of Option contracts or Options as they are commonly called.
Are Options the Same Thing as Derivatives?
No, they are not! Options or Options contracts are a part of the group of securities called Derivatives but they are not the same thing as them. A financial contract, a Derivative gets its structure, value, and risk from an underlying asset. Options, on the other hand, are a type of Derivatives that give the holder the right or ‘option’ to buy or sell the underlying asset without putting them under the obligation to go through with the transaction. Options are available for several types of investments including commodities, currencies, and equities.
The reason Options are categorized as Derivatives is because their value is derived from an underlying asset, which is a primary quality that defines derivatives. There are several reasons for investors to want to use Options including hedging risk, speculating, and income purposes. Options can be categorized into several types, including:
- Call Options
- Put Options
- American-Style Option
- European-Style Option
- Exchange Traded Option
- Over-the-Counter Option (OTC)
While there are several types of Options to choose from, the two main types of Option contracts are calls and puts. These are also the most commonly used ones. This is the reason why we will be discussing only these two types of Options here.
What Makes Call Option Different from Put Option and Vice Versa
Although they both allow you to diversify a portfolio and earn another income stream, calls and puts are two entirely different things. If you want to make the most out of each Option contract type, then you would do well to understand the difference between them. To help you differentiate, I provide an explanation of both call option and put option with examples. I will start with the call option and its example.
1. Understanding Call Options
The call option allows the buyer to buy the shares of the underlying security at a strike or specified price in the option contract. However, the buyer is under no obligation whatsoever to go through with the transaction or buy the underlying asset.
In case the holder wants to exercise their right to buy the shares of the underlying asset, then it becomes obligatory for the call option writer to sell them those shares. Calls are typically bought when there is a strong chance that the price of the underlying asset will increase. On the other hand, they are sold when investors expect their price to decrease.
An important thing to keep in mind is that the holder must exercise their right before the expiry date of the option contract. After the expiry date, the call option has no worth. One of the best things that anyone can do before buying calls is surveying the market to ensure that the price of the underlying security will increase. The value of the security or asset may dip after the call option is bought, causing the contract to expire before any move is made. In this case, the writer of the call option benefits from the agreement. To help you better understand calls, the following is an example that explains the call option.
Example of Call Option
Here is a hypothetical scenario to explain the call option. Let’s suppose the shares of Procter and Gamble (P&G) were trading on the NYSE at $14 each. Now, an investor who expects P&G’s market value to rise will buy a call option. The call option’s strike price is set at $16 and its expiry is in one month.
The premium paid to the writer of the call option is $100 for 100 shares of the underlying stock. If the stock price of P&G increased beyond $16 to say $20, then the holder of the call option can exercise their right to buy 100 shares of P&G at $16. The writer of the call option would have to sell the shares at the strike price instead of the current $20 stock price.
The holder of the call option can then sell the 100 shares at the current $20 price immediately after receiving them. By selling the 100 shares at the $20, the holder would make a profit of $400 as they pocketed a profit of $4 per share. Even if you take subtract the premium paid for the call option from this amount, the holder is still left with a healthy $300 profit.
However, if the P&G stock price does not exceed the $16 strike price before the expiration, then the holder of the call option won’t be able to buy any shares from the writer. Instead, the writer will take home the $100 premium that was paid to them for the call option. Makes sense? I’m sure it does!
2. Understanding Put Option
The holder of the put option has the right to sell shares of an underlying security before the expiry date. In case the holder wants to exercise their right to sell the shares of the underlying asset, then it becomes obligatory for the call option writer to buy those shares from them. Puts are typically bought when there is a strong chance that the price of the underlying asset will decrease. On the other hand, they are sold when investors expect their price to increase.
Just like in the case of the call option, the holder of the put option must exercise their right before the expiry date of the option contract. After the expiry date, the put option has no worth. Following is an example that explains the put option.
Example of Put Option
Let’s suppose the shares of Coca Cola were trading on the NYSE at $12 each. Now, an investor who expects Coca Cola’s market value to drop buys a put option in hopes of making a profit. The put option’s strike price is set at $8 and its expiry is in two weeks.
The premium paid to the writer of the put option is $100 for 100 shares of the underlying stock. If the stock price of Coca Cola decreased beyond $8 to say $6, then the holder of the put option can exercise their right to buy 100 shares of Coca Cola at $6 and then sell them at $8 each. The writer of the call option would be under obligation to buy the shares from the holder at the strike price of $8 per share. This way the put option holder is able to generate a profit of $200 ($2 profit per share × 100). If you subtract the premium paid for the put option from this amount, the holder is left with a $100 profit.
However, if the Coca Cola stock price does not go below the $8 strike price before the expiration, then the holder of the put option won’t sell the shares to the writer for a profit. Instead, the writer will take home the $100 premium that was paid to them for the put option.
Calls and puts can be a bit difficult to understand, especially if you’re starting out with stock investing. However, the above information about the call and put options should be a good reference point for you to make an informed decision about a call or put option.
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Comment down below if you ever have used the stock options strategies mentioned above and how have they helped your portfolio?