Options are special contracts that give investors the choice to buy or sell a particular asset at a set price. There are two main kinds: call options, which allow buying, and put options, which permit selling.
Call options allow the contract holder to buy the asset, while put options grant the right to sell it. Both help investors gain from changes in a stock's value. But, they work differently and have key distinctions.
|Gives the holder the right to buy shares
|Gives the holder the right to sell shares
|Option seller has unlimited risk
|Option seller has limited risk, equal to the strike price multiplied by the number of shares involved
|Option buyer has limited risk
|Option buyer has limited risk
The main contrast between call options and put options lies in the rights they give to the contract holder.
When you purchase a call option, you're getting the chance to buy shares at a specific price mentioned in the contract. You expect the stock's price to go higher than this set price. If it does, you can buy shares at this lower price and sell them quickly at a higher market price to make a profit.
When you get a put option, you're acquiring the ability to sell shares at a fixed price listed in the contract. You want the stock price to drop. If the stock price falls below this set price, you can sell the shares at a higher price than the current market value, making a profit.
When you sell an option, you get paid a premium by the buyer. But, you're agreeing to either buy or sell shares at a fixed price stated in the contract if the buyer decides to use their option.
When you sell a call option, the person who buys it can buy shares from you at a specific price. If the stock price goes up more than that set price, the buyer can use their right to buy shares from you at a lower price than what the market offers. This situation theoretically exposes you to unlimited risk because there's no cap on how high the stock price might go and when the buyer might decide to buy the shares.
If you sell a covered call (owning the shares), you might sell those shares at a much lower price than what the market offers, missing out on a significant profit. But if you sell a call option without owning the shares, you'll have to buy those shares at a very high market price and then sell them at the lower strike price, leading to a potentially huge loss without a fixed limit.
On the flip side, sellers of put options have limited risk. When you sell a put option, you're granting the option holder the right to sell you shares at a specific price. If the stock price drops below that price, the put option buyer can use the contract, making you buy shares at a higher price than the market.
The lowest value a stock can reach is ₹0. If this happens, the option holder could use their right to sell shares at the agreed price, leaving you with worthless stocks. However, because stock prices can't go below ₹0, the maximum loss you could face can be calculated using the following formula:
Maximum loss for put option seller=(Strike price * Number of shares included in the contract) - Premium received
When someone buys an option, they pay a premium to the seller of the contract.
People holding options can decide to use them, but they don't have to. Most times, it's not beneficial to use the option unless it's "in the money."
For instance, if a stock is priced at ₹59 and you have a call option with a ₹60 strike price, it's smarter not to use the option to buy those shares. Why? Because you can buy the same shares for ₹1 less per share in the regular market.
Likewise, if you have a put option and the stock is priced at ₹60, and your put option's strike price is ₹59, it's better not to sell the shares using your option. That's because you can sell them at a better price in the regular market.
Since there's no requirement to use an options contract, the most a buyer can lose is the amount they paid for the premium.
Deciding between a call option or a put option depends on your position in the trade and what you think will happen to prices.
If you're purchasing options, go for a call if you expect prices to go up, or choose a put if you believe prices will drop. This way, you can buy stocks at a lower price or sell them at a higher one, respectively.
Let's say Jane thinks XYZ, currently priced at ₹50, will go up. She buys a call option for ₹55, paying ₹125 as the option's cost for 100 shares.
If XYZ rises above ₹55, she can use the option to buy 100 shares for ₹5,500. Including the premium, she'll spend ₹5,625 for the shares. She'll make a profit whenever XYZ's price is over ₹56.25. If XYZ doesn't hit ₹55, she'll lose the ₹125 premium.
If Jane thinks XYZ will drop, she might buy a put option instead. The put option costs ₹125 and has a strike price of ₹45. If XYZ falls below ₹45, she can exercise it. Her profit would depend on the difference between the option's strike price and the lower price of XYZ.
((Current share price - 45) * 100) - ₹125)
If the price of XYZ remains higher than ₹45, Jane won't use the option, and she only loses the ₹125 premium she paid.
Investors can use a mix of puts and calls to make clever options plans, aiming to make money even when a stock's price stays within a certain range.
For instance, a short strangle strategy means selling a call option with a higher strike price than the current share price and selling a put option with a lower strike price than the current share price.
Suppose XYZ is at ₹50. Jane can sell a call at ₹55 and a put at ₹45, getting paid for both deals. As long as the stock stays between ₹45 and ₹55, neither buyer will act on their options. But if the stock moves a lot in any direction, Jane might lose money if the buyers decide to use their contracts.
There are more complex plans involving buying and selling calls and puts at various prices and combinations. Using options cleverly, you can aim to profit from different types of market movements.
Options are contracts allowing you to purchase or sell the right to buy or sell stocks at a fixed price. Buying options comes with limited risk, but selling them can bring about considerable, potentially limitless risk. It's important to consider this when deciding whether to buy or sell options and the type of options to use in your investment plan. Also, keep in mind that dealing in derivatives carries more risk than trading stocks.
Usually, it's a good idea to use options when they're "in the money." With put options, this occurs when the stock price is lower than the option's strike price. For call options, it happens when the stock price is higher than the option's strike price.
Selling call options earns you money through the premium received. Buying call options can make you money if the stock price goes higher than the strike price. If this occurs, you can use the option to buy shares at a price lower than what they're selling for in the market. Selling these shares afterward allows you to make a profit.
To sell put options, begin by creating an options account using an options trading platform or your brokerage service. After setting up the account, you can place a sell order for put options, mentioning the strike price, expiration date, and the specific stock.
For additional content like this, consider subscribing to The Balance’s newsletter. Receive daily insights, analysis, and financial tips directly in your inbox every morning!