Here’s how call and put options work in a nutshell.
Differences between Calls and Puts
An investor will use a put option when they are worried that a stock they own is dropping. Using a put seller, the interested buyer pays a premium, or a put, and has the option to buy the stock at the strike (I explain what a strike is shortly). The buyer then has one of two options, they can either buy at the strike price, which is lower than the market value or they can walk away from the sale. If the buyer walks from the sale, they will only lose a fraction of the stock’s price because put seller keeps the premium.
Put options are contrasted with call options. A seller, in this case, might use a call option, which is also a way to hedge their risks. Call options give a buyer the chance to put a premium down on a stock they think is a going to drop and can buy at a lower price. But if something changes, they can walk away and all they lose is the partial payment.
One thing to keep straight, buyers use put options while sellers use call options. But both options give the buyer the right, but not the obligation, to buy a stock at a specific price within a set time period.
Let’s get more detailed than that, shall we?
Why Use Options?
Options are strategies investors use that are designed to hedge some of the risks inherent in the stock market. In simple terms, an option is when a price and expiration date are set on a specific stock. The option earns the buyer the “right” but not the “obligation” to buy a stock. Using options can help mitigate potential losses when buying or selling stocks.
With an option, an investor hedges their risks because a call or put option works a lot like an insurance plan. The bottom line with options is that a buyer or seller can use these strategies to prevent losing money on a stock. To prevent major losses an option seller benefits because they essentially act as an insurance company and so they profit from the premiums paid.
A Closer Look at Options
Remember, a call option gives the owner of a stock the right to sell at a specific price; while a put option gives the owner the right to buy at a specific price.
Here’s how that works:
Right away, it is important to remember that options don’t require the investor to buy or sell the stock. This is one of the primary reasons they are useful. Instead, they give them the right to buy or sell before the deadline. There are definite advantages to hedging your bets when it comes to day-trading, and sometimes it is better to walk away from a deal with a small rather than total loss.
Two important aspects of options are predictions and risks. If one is using an option to put or call, it could be because the investor might be interested in new or a volatile stock. Options can be used for any stock. But the strategy is primarily used by investors with large holdings in an effort to reduce potential or real losses.
The other aspect of an option is that essentially the investor is not willing to pay the market value of the stock. Rather, they believe that the future price they predict is correct and the asset will fall to match that price before the order deadline. With quality predictions, options are a good way to make quick profits, because the investor buys low and sells high. And, if the price is not met, then the investor only has a partial loss.
Buying at the Strike
It is also helpful to know what a strike price is when talking about puts and calls.
A strike price is contrasted with the market price. The option contract sets the strike price. It is the fixed price at which the owner of the option can buy or sell the stock. The strike price is decided on based on a reference to the market price of the underlying security. The strike of an option is based on the day that the option is taken out. It might also be fixed at a discount or at a premium in some cases.
Essentially, the strike is less than the market price but is still a reflection of the value of a stock.
Put Options a Little Slower
It is called a “put option” because, by way of the options contract, the owner gains the right to “put up for sale” the stock that another may buy.
As I mentioned earlier, a put option is a contract that gives the owner the right to sell a stock. However, puts are not obligations to sell. The way this works is that a seller pays the “put seller” a premium which is a lot like buying insurance on the stock.
In this case, the put writer sells the protection plan to the buyer. Within the given time frame, the buyer can decide to buy the stock at the price of the strike or to walk away from the deal. If the buyer walks, then the put writer must buy the stock at the strike price. So, the buyer earns the option to buy the stock or to walk.
When you are the put buyer, the best scenario is for the stock price to drop below the strike. If the stock drops below the strike, the put seller must buy the shares at the strike price. If the stock drops, the seller pays out the buyer for their losses. This is why this is used as an insurance policy if the investor believes the stock will drop. The buyer does not lose the full price of the dipping stock.
However, what if the stock goes up and the shares increase in value? In this case, the buyer can let the option expire if they do not want to pay the inflated price. By letting the option expire, the buyer loses only what they paid for the option. And the seller of the option keeps the premium that was paid for the put order contract. In this way, a put is beneficial for the buyer because, within the set time period, they can buy the stock at the strike price. However, if they change their mind, they can walk away from the sale. If the investor walks away from the sale, they will only lose the premium they paid the put seller, and nothing more.
Why Put?
This is why a put is similar to the way that you buy insurance for your car or house. If you think of car insurance, your premiums are based on the value of the car. Then if you have an accident, you do not pay the full price of the accident, but only part of it.
The strategy is similar with put options; essentially the investor hopes that the stock’s value will fall before the deadline arrives. A put option purchase can be interpreted as a negative sentiment about the future value of the underlying stock. It indicates the belief that the stock will drop in value.
Call Options a Little Slower
A call option means that the owner has the right to “call the stock away” from the seller.
With a call option, the investor buys the right to purchase a stock from the seller of that at the predetermined strike price. The contract must occur within the agreed upon time frame. To purchase a call option, the buyer pays the seller a premium, which is based on a percentage of the stock price.
When one hopes that in the near future the market price of the stock will increase, a call can be used. Because if the price goes up over the strike price of the option, the buyer can use their call and buy below market value. If the stock price exceeds the strike, then the buyer has essentially turned a profit, buying the valuable assets for less than market value.
On the other hand, if the price of the stock drops, the holder of the call can let the contract expire. This way the only loss is the cost of the premium.
Here’s how it works. The prospective buyer pays a premium for the right to call. Then the buyer has the right to buy a stock at a predetermined price, before a set deadline. With a call option, if the stock does not sell above the strike then the seller keeps the premium from the buyer. The buyer is still not obligated to buy the stock and may not if the stock does not rise above the strike. But if they do not buy the stock, the buyer loses his premium to the call seller.
With a call, if the stock rises above the strike price, the option buyer will exercise their right to buy the stock at the strike price. When this happens, the option writer does not profit on the stock’s movement above the strike price. The options seller will have a maximum profit from the premium received.
Reasons for the Owner to Call an Option
Tax Management:
If an investor owns 50 shares of ABC, the stock may be subject to large unrealized capital gains taxation. To avoid a higher taxation level, shareholders can use options to reduce the appearance of the underlying security. This happens without actually selling the stock. Instead, the stock is valued at the strike price and not at the market value.
Using Options for Income:
Option contract premiums alone can be profitable. An investor can collect on the option premium and with the hope that the option will expire below the strike price. On a dropping stock, this strategy generates income for the investor.
Speculation:
The primary benefit of buying call options is that the potential loss if the stock will not rise about the strike is the premium paid for the option.
Options In Brief
- Call Options: The owner gives a buyer the right to buy at the strike (the reduced rate). The buyer pays a premium for the right to this option. However, the buyer does not have to follow through with the purchase. The buyer may walk away if the stock does not rise about the strike. The point is for a buyer to get a stock at a reduced rate. While the owner of the stock will keep the premium paid by the buyer. A call is placed on a stock that is likely to drop, which comes with an expiration date.
- Put Options: The opposite of the call option is the put option. A put gives the buyer the right but not the obligation to buy at the strike price.
- Both represent an effort to protect a losing asset or to earn on a stock purchased at the strike. The primary difference is that a put is an order to buy, and a call is an order to sell. And both can be thought of as a way to mitigate potential loses from either the perspective of the seller or buyer.
Final Note
As you may have gathered from this article, this is not necessarily a strategy that many investors need to use. This is primarily a tactic that investors with large holdings tend to utilize. These are the individuals with large net worth that can both afford to ensure their holdings, as well as swallow significant losses. One final note; several cryptocurrency explorers offer call and put options for coins. But options are much more common for trading secured stocks.
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