Call and Put Options

Calls and Puts are the most common types of stock options. Call is a bullish bet the buyer makes on the stock, while Put is a bearish bet.

Options allow you to participate in the price movement of the underlying asset with a much smaller investment than owning the asset outright; this is akin to a financial leverage. Having an outlook on the stock (please read “How to Analyze Stocks”) is the first step to selecting an option strategy. Stock options are sold as contracts, in which one contract equals 100 options. Options for most of stocks usually expire the third Friday of the month. However, popular stocks can have options that expire every Friday of the month.

The Call option is a contract that gives a buyer the right (but not the obligation) to buy the stock at Strike price (K) before the expiration date. It is a bullish bet made by the options buyer that the stock price (S) will rise above K before expiration. If this bet is correct, then the buyer can buy the stock low (at K) from the seller of the Call option and sell it high in the market thus realizing a profit of S – K. If the bet is incorrect, then the option will expire as worthless.

The cost of options is called option premium (P), which the options buyer pays to the seller. Selling an option is also referred to as Writing. The Call option is said to be in-the-money when S>K and out-of-the-money when S<K. The buyer makes S – K – P when the stock trades in-the-money range and loses P when it trades out-of-the-money. The seller makes P when the stock trades out-of-the-money and loses -S+K+P when it trades in-the-money. The upside potential for the buyer and the downside risk for the seller are both unlimited as the stock price increases.

The Put option is a contract that gives a buyer the right (but not the obligation) to sell the stock at Strike price before the expiration date. It is a bearish bet made by the options buyer that the stock price will fall below K before expiration. If this bet comes true, then the buyer can buy the stock low from the market and sell it high (at K) to the seller of the Put option thus realizing a profit of K – S. If the bet fails, then the option will expire worthless.

The Put option is said to be in-the-money when S<K and out-of-the-money when S>K. The buyer makes K – S – P when the stock trades in-the-money range and loses P when it trades out-of-the-money. The seller makes P when the stock trades out-of-the-money and loses -K+S+P when it trades in-the-money. The upside potential for the buyer and the downside risk for the seller are limited to the difference between the strike price and the premium paid if the stock price falls to zero.

Option prices are determined using the Black-Scholes model and notwithstanding market supply-demand dynamics. Using this model, the Call option price increases with an increase in stock price, time of expiry, volatility or interest rate, or a decrease in strike price. The Put option price increases with an increase in strike price, time of expiry or volatility, or a decrease in stock price or interest rate.

To close out an option position and realize a profit, the investor does not actually need to go through a stock trade but can directly trade in options. The basic Call and Put options can be combined to form advanced trading strategies discussed in “Popular Option Strategies.”

We specialize in tax-free retirement strategy and investments such as IUL, Annuity and LTC. Prefer a quick and complimentary consultation? Just email us at Karthik@FinCrafters.com

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