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Call and put options are contracts that give buyers the right but not the obligation to buy (call) or sell (put) an asset at a set price by a certain date. They’re like agreements where you can decide whether to buy or sell something later but you don’t have to if you don’t want to.
Call options let you buy an asset at a predetermined price while put options let you sell an asset at a predetermined price.
These options can be broken down further but this blog will give you a clear understanding of what call and put options are all about.
Call and Put Options for Beginners
| Underlying Asset's Price | What to Do? |
|---|---|
|
Probability of increasing
|
BUY call option or SELL put option
|
|
Probability of decreasing
|
BUY put option or SELL call option |
- US Option Contracts: These allow you to exercise the option anytime before it expires.
- European Option Contracts: These only let you exercise the option on the expiration date.
If you’re trading call and put options in the US market you can close out your position at any time before the option expires.
Call option is like an agreement where you get the right to buy something like a stock or a commodity at a set price. But you don’t have to purchase it if you don’t want to. These agreements have an expiration date
so you have to decide whether you want to buy the thing before the deadline or not. You can use call options for all sorts of things not just stocks like currencies or ETFs.
How Do Call Options Work?
Call option contracts traded on securities exchanges give the option buyer the right but not the obligation to buy a specific security at a set price.
let’s say you believe the stock market will go up soon. You notice a positive trend starting and want to take advantage of it. So you can buy a call option at a certain price.
If your prediction is correct and the market goes up, the value of your option contract goes up too. Since options are based on other assets their value is decided by buyers and sellers. When the market price is higher than the contract’s price at the end the call option is “in-the-money,” meaning you can sell it for a profit.
Did You Know?
Initially, options were limited to stocks and indexes. However, over time the options market has expanded. Nowadays investors can trade options on various financial instruments like commodities, currencies and even cryptocurrencies.
Let’s assume the stocks of Reliance are currently trading at ₹100 per share. Investor A is a long-term investor and holds 1,000 shares in Reliance. Stock price is expected to rise in the next few weeks. However, A does not wish to sell his investments to capitalize on this increased value.
Instead A decides to buy a call option for Reliance. He purchases a lot of 100 shares and a strike price of ₹150 the call option premium is ₹0.50 per share.
Initial Cost Price = ₹50
Now, A’s prediction comes true and a month later stock price for Reliance rises to ₹150 from ₹100. means A’s call option now has intrinsic value and its price rises to ₹1.50 from ₹0.50. A is able to sell the entire lot at the higher price of ₹1.50.
Selling Price = ₹150
Total Profit = ₹100
This way A is able to generate a profit of ₹100 without selling his investment in Reliance.
Put option is a derivative contract gives buyer right to sell the underlying asset at the specified strike price, there is no obligation for the buyer to do the same. Investors buy puts only when they expect underlying asset’s price to decrease. Likewise, investors sell puts once they think that the underlying assets will increase.
Similar to call options, put options are tradable across a variety of assets such as stocks, currencies, swaps, ETFs, and other financial instruments.
How Do Put Options Work?
Put option lets the buyer sell the underlying asset at a set price. Its premium increases when the stock price falls and decreases when the stock price rises. It’s commonly used to hedge against downward moves in a long stock position.
If a put option expires profitably investor may exercise their right to sell. If it expires unprofitably investors can choose not to exercise considering the premium paid as a loss.
When the put option’s strike price is higher than the market price it’s out of the money. When it’s lower it’s in the money and when both are equal it’s at the money.
Just like Investor A, Investor B also owns 1,000 shares of Reliance which are currently priced at ₹150 per share. However Investor B thinks the price might drop soon.
To protect against this potential drop Investor B decides to buy a put option. He purchases a lot of 100 shares and a strike price of ₹100 at a premium is ₹0.50 per share.
Initial Cost: ₹50
Investor B’s prediction comes true and the price of Reliance shares falls to ₹100 from ₹150 means Investor B can sell their options at a higher price than the market price. Price of the put option rises to ₹1.50 from ₹0.50 and Investor B decides to sell their entire lot at this new price.
Selling Price: ₹150
Total Profit: ₹100
This way Investor B makes a profit of ₹100 without having to sell their original Reliance shares.
Terms Related To Call And Put Options
Now you have understand what are call and put options, let’s look into the basic terms:
- Spot Price: It's the current price of underlying asset.
- Strike Price: Agreed price at which buyers and sellers agree to trade the underlying asset after a specific period.
- Option Premium: It's the upfront fee paid by the buyer to the seller for the option.
- Option Expiry: The date when the option contract ends.
- Settlement: In India options are settled in cash meaning the difference in value is paid out rather than exchanging the actual asset.
Difference Between Call Option and Put Option?
Some of the differences between the call option and the put option are mentioned below:
| Aspect | Call Option | Put Option |
|---|---|---|
|
Meaning |
Call option provides purchasing rights to the buyer but without any obligation of buying.
|
Put option provides selling rights to buyer without any obligation to sell.
|
|
Investor Expectations
|
Buyers of call options expect that the stock prices will increase. |
Buyers of the put option determined that the stock prices would decrease
|
|
Gains |
Unlimited gains for a call option buyer
|
Gains for a put option buyer are capped because the stock price can't fall to zero, even if the company goes out of business
|
|
Loss |
Loss for a call option buyer is usually restricted to the premium they paid initially. |
Maximum loss for a put option is the strike price - premium amount
|
|
Dividend Reaction
|
While the dividend date nears the call option loses value |
As the dividend data nears, value of put option increase. |
How to Calculate Call Option Payoffs
Call option payoff indicates the profit or loss for the option buyer or seller. It’s influenced by three main factors: expiry date, strike price and premium.
These factors are crucial for understanding how call options perform.
Imagine you buy a call option for a company paying a premium of ₹100. Option has a strike price of ₹500 and expires on 30th January
If the company’s stock price reaches ₹600, you’ll just about break even on your investment. Any increase beyond this is considered profit potentially leading to unlimited gains as the stock price rises.
Payoff = Spot Price – Strike Price
= ₹600 – ₹500
= ₹100
Profit = Payoff (₹100) – Premium Paid (₹100)
= ₹100 – ₹100
= ₹0
When you sell an option with the same expiry and strike, you can profit if the stock price drops. Your losses depend on the nature of your option and can potentially be unlimited.
If you’re obliged to purchase the underlying stock at spot prices, your losses can be unrestricted. However, your income is capped at the premium received when the option contract expires.
Let’s assume you have sold a call option with a strike price of ₹2,000 and receive a premium of ₹200. At expiry the stock’s spot price is ₹1,800.
Payoff = Spot Price – Strike Price
= 2,000 – 1,800
= 200
Therefore, your profit from selling the call option would be the premium received: ₹200.
How to Calculate Put Option Payoffs
Total profit or loss from a put option trade is determined by two factors:
- Difference between the strike price and the current price of the asset.
- Initial amount paid for purchasing the option.
Profit or loss of the option buyer depends on the current price of the asset. If the market price falls below the strike price at expiration buyer stands to gain. The deeper the drop in price more profit the buyer can make.
However, if the market price exceeds the strike price buyer may let the option expire resulting in a loss equivalent to the premium paid for the put option.
Suppose you purchase a put option for a company at a premium of ₹100 and a strike price of ₹500. If the stock price falls to ₹400, you might choose to exercise the option as the market price decreases and your potential profit increases.
Payoff = Strike Price – Current Price
= 500 – 400
= ₹100
Profit = Payoff – Premium Paid
= ₹100 – ₹100
= ₹0
When selling a put option seller receives a premium from the buyer. Buyer’s profit or loss depends entirely on the current price of the underlying asset.
Any profit gained by the buyer typically results in a loss for the seller. If, at expiry current price is lower than the strike price put option will be exercised resulting in a loss for the seller. Conversely, if the current price is higher than the strike price buyer lets the option expire unused and seller keeps the premium.
Let’s say you sold a put option for a company at a premium of ₹200 with a strike price of ₹1,800. Now, if the company’s stock price has risen to ₹2,000
Payoff = Strike Price – Spot Price
= ₹1,800 – ₹2,000
= -₹200
The seller’s profit is:
Profit = Payoff + Premium Received
= -₹200 + ₹200
= ₹0
According to this calculation your profit would be ₹0. However, If the stock price is above the strike price put option expires worthless and your profit is simply the premium received. So, in this case your profit should be ₹200.
Call Option and Put Option: Risk vs Reward
| Aspect | Call Option Buyer | Call Option Seller | Put Option Buyer | Put Option Seller |
|---|---|---|---|---|
|
Maximum Profit |
Unlimited |
Premium amount received |
Strike Price-Premium Paid |
Premium amount received |
|
Maximum Loss |
Premium Paid |
Unlimited |
Premium Paid |
Strike Price-Premium Paid |
|
Breakeven |
Strike Price+Premium Paid |
Strike Price+Premium Paid |
Strike Price+Premium Paid |
Strike Price+Premium Paid |
|
Action |
Exercise |
Expire |
Exercise |
Expire |
What Happens to Call Options When They Expire?
Buying Call Option:
- Market Price < Strike Price = Out of the money = Loss
- Market Price > Strike Price = In the money = Gains
- Market Price = Strike Price = At the money = Breakeven
Example
- Strike Price = ₹1,000
- Market Price at Expiry: ₹900 = Loss
- Market Price at Expiry: ₹1,100 = Gains
Selling Call Option
- Market Price < Strike Price = Out of the money = Gains
- Market Price > Strike Price = In the money = Loss
- Market Price = Strike Price = At the money = Profit (Premium)
What Happens toPut Options When They Expire?
Buying Put Option
- Market Price < Strike Price = In the money = Gains
- Market Price > Strike Price = Out of the money = Loss
- Market Price = Strike Price = At the money = Loss of Premium
Example
- Strike Price = ₹1,000
- Market Price at Expiry: ₹900 = Gains
- Market Price at Expiry: ₹1,100 = Loss
Selling Put Option
- Market Price < Strike Price = In the money = Loss
- Market Price > Strike Price = Out of the money = Gains
- Market Price = Strike Price = At the money = Profit (Premium)
As we wrap up our first blog on Futures and Options, we sincerely hope you’ve found it informative and insightful. We aimed to provide a clear understanding of the basics of call and put options. Stay tuned for our upcoming blogs where we’ll explore more topics.
Keep learning and keep earning!
Until then, Tata!
Happy investing and thank you for reading!
Disclaimer:
This website content is only for educational purposes, not investment advice. Before making any investment, it’s important to do your own research and be fully informed. Investing in the stock market includes risks, and you should carefully read the Risk Disclosure documents before proceeding. Please remember that past performance doesn’t guarantee future results, and due to market fluctuations, your investment goals may not always be achieved.
