What are Call and Put Options?

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Options are "derivative investments", meaning the price movements of the investments are based on the price movements of another financial product. The financial product from which the derivative is obtained is called the "underlying."

Call and Put Options

Options are contracts that provide the buyer the right to buy or sell an underlying asset, at a predetermined price and before a specific date.

  • A call option is bought by a trader if the investor expects the price of the underlying to rise within a certain time frame.
  • A put option is bought by a trader if he/she expects the price of the underlying to fall within a given time frame.

How Call Options Work

  • For American-style options, the call option buyers get the right to buy an underlying asset at a pre-decided price at any time before expiry.
  • In case of European-style options, the buyers may exercise the option— to buy the underlying—only on the expiration date. Options expirations may vary and can be either short-term or long-term.

Here, the strike price is that at which a put buyer can sell the underlying asset. For example, the investor who chooses to go for a stock put option with a strike price of $10 can use the option to sell that stock at $10.

The Buyer Gets 

The call buyer can buy a stock at the strike price before the expiration. To get the right, the call buyer needs to pay a premium. If the underlying’s price moves above the strike price, the option will be worth money. The buyer can sell the option for a profit or exercise the option, which means he would receive the shares from the person who wrote the option).

The Call Seller Gets

The call writer/seller which is usually a bank receives the premium. Writing call options is a way to generate income. However, the income from a call option is limited to the premium, but a call buyer has theoretically unlimited potential of earning profit.

Calculating the Call Option's Cost

One stock call option contract usually contains 100 shares of the underlying stock where each stock's call prices are basically quoted as per share rate. Therefore, to determine the price of a contract, the price of the option should be multiplied by 100.

Call options can be "in", "at", or "out of" the money −

  • In-the-money refers to the underlying asset price that is above the call strike price.
  • Out-of-the-money refers to the underlying price that is below the strike price.
  • At-the-money is when the underlying price and the strike price are the same.

How Put Options Work

  • For American-style options, a put options contract provides the buyer the right to sell an underlying asset at a predetermined price at any time up to the expiration date.
  • The purchasers of European-style options should exercise the option, that is sell the underlying only on the expiration date.

Here, the strike price is that at which a put buyer can sell the underlying asset. For example, the investor who chooses to go for a stock put option with a strike price of $10 can use the option to sell that stock at $10.

The Put Buyer Gets 

The put buyer gets the right to sell a stock at the strike price. For gaining that right, the put buyer needs to pay a premium. When the underlying’s price moves below the strike price, the option will be worth money. The buyer can also sell the options for a profit or exercise the option, that is sell the shares.

The Put Seller Gets 

The put seller, or writer, gets the premium from the sale. Writing put options is also a way to generate income. However, generating income from writing put options is limited to the premium, while a put buyer can continue to maximize their profit until the stock price goes to zero.

Calculating the Put Option's Cost

Put contracts also represent 100 shares of the underlying stock. To find the price of the whole contract, one needs to multiply the underlying's share price by 100.

Put options can be "in", "at", or "out of" the money, just like call options −

  • In-the-money refers to the fact that the underlying asset price is below the put strike price.
  • Out-of-the-money refers to the fact that the underlying price is above the strike price.
  • At-the-money implies that the underlying price and the strike price are the same.
raja
Published on 04-Oct-2021 08:31:36
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