Definition
A Call Option is a financial contract granting the holder the right, but not obligation, to buy an asset, usually stocks, at a predetermined price within a specified time period. Conversely, a Put Option is a financial contract that gives the holder the right, but not the obligation, to sell an asset at a predetermined price within a specified time period. Thus, call options are typically used when market prices are predicted to rise, while put options are used when prices are expected to fall.
Key Takeaways
- Call Options give the buyer the right, but not the obligation, to buy an asset at a specified price within a specific time period. Puts, on the other hand, offer the right to sell an asset at a specific price within a specific time period. Their mechanisms work in opposite directions.
- When you buy a Call Option, you expect the price of the underlying asset to rise, enabling you to purchase it at a lower price than its market value. But when you buy a Put Option, you anticipate the price of the underlying asset to fall, allowing you to sell it at a higher price than its market value.
- The pricing of both Call and Put Options are influenced by several factors including the price of the underlying asset, the strike price, the time remaining until expiration, the volatility of the underlying asset, and interest rates. However, the relationship between these factors and the pricing of Call and Put Options may vary.
Importance
Understanding the difference between call and put options is crucial in finance as these are fundamental tools used in derivatives trading.
A call option gives the holder the right (but not the obligation) to buy an asset at a set price within a specific period, used in anticipation of a price rise.
In contrast, a put option allows the holder to sell an asset at an agreed price within a specified timeframe, particularly when a price drop is expected.
Knowing when to appropriately use these options can provide investors with strategic methods to maximize profits, hedge risks, and potentially leverage their investment capital.
In essence, the understanding of call and put options directly impacts investment strategies and decision-making in financial markets.
Explanation
Call options and put options are two distinct types of financial instruments used by traders and investors to manage the risks and benefits associated with stock ownership. The primary purpose of a call option is to offer the investor or trader the right, but not the obligation, to purchase a specific amount of shares at a designated price within a certain period.
This tool is often used in anticipation of a rise in the value of a particular stock, allowing the buyer to potentially procure shares at a lower price than their market value. It essentially provides an opportunity for individuals to leverage their positions and potentially profit from the future movement of a stock without necessarily owning it.
On the other hand, a put option gives the buyer the right, but not the obligation, to sell a certain amount of shares at a designated price within a specified time frame. These are typically used when an investor or trader anticipates a decrease in the stock’s price, thereby providing a way to potentially profit from a decline in stock value.
A put option essentially provides an insurance policy against dropping stock prices. By using both these financial instruments, traders and investors can better manage their risks, secure their investments and potentially profit from market fluctuations.
Examples of Call Options vs Put Options
Example 1 – Call Option: Let’s say you’re an investor who believes that the price of Apple Inc. shares is going to increase from its current price of $150 in the next few months. So, you decide to buy a call option that allows you to buy 100 shares of Apple at $150 (the strike price) three months from now. If the price of Apple shares does indeed rise to $200 within that period, you can exercise your call option, buy the shares at $150 and sell them at the market price of $200, making a profit.
Example 1 – Put Option: Conversely, let’s assume that instead of anticipating a rise, you suspect the shares of Apple are going to fall from their current price of $
In this situation, you can buy a put option to sell 100 shares at the strike price of $
If the price falls to $100 you can buy the shares at the lower market price and then sell them using your put option at the higher strike price, thus making profit.
Example 2 – Call & Put Options Together: Consider that you currently own 100 shares of Netflix, Inc and suspect the price may experience high volatility in the next few months due to an upcoming earnings report but you’re unsure as to which direction it will go. To protect your investment, you can buy a put option which will allow you to sell your shares at a set price, protecting you from a potential price decline. Simultaneously, you believe there’s potential for the stock to surge. So you buy a call option for an additional 100 Netflix shares. Now, regardless of how the stock price changes after the earnings report, your potential losses are limited while your potential gains are unlimited.
Frequently Asked Questions
What are Call Options?
A call option is a financial contract between two parties where the buyer has the right, but not the obligation, to buy an asset at a specified price within a specified period. The seller is obliged to sell the asset if the buyer exercises the option.
What are Put Options?
Put options are contracts that give the option buyer the right to sell the underlying asset at a specified price within a specific period. The seller, on the other hand, is obliged to buy the asset if the holder chooses to exercise his option.
What are the Key Differences between Call Options and Put Options?
The primary difference between a call option and a put option lies in their payoff. A call option allows the option holder the right to buy an asset at a decreased market price, while a put option permits the holder to sell an asset at an increased market price.
When do Investors Buy Call Options?
Investors buy call options when they believe the price of a stock or commodity is going to go up in the foreseeable future, allowing them to profit from such an increase.
When do Investors Buy Put Options?
Investors buy put options when they anticipate the price of a stock or commodity to decline within a certain time period, giving them the ability to profit from the drop.
Related Entrepreneurship Terms
- Strike Price: The pre-agreed price per share at which stock may be bought or sold under the option contract in a call or put transaction.
- Exercise Date: The date by which the option contract must be exercised or it will expire, also known as expiration date.
- Premium: The sum paid for the option. This is the income an option seller receives and risk the option buyer takes on to have the choice to buy or sell an asset in future.
- In-the-Money: A term for an option which could be profitably exercised immediately. For call options, this is when the underlying asset’s price is higher than the strike price. For put options, it’s when the underlying asset’s price is lower than the strike price.
- Underlying Asset: The financial instrument (e.g., a stock, futures, commodities, currency pairs, or indexes) which the option gives you the right to buy or sell at the strike price.
Sources for More Information
- Investopedia: This website provides many deep-dive articles explaining various finance terms including call options and put options.
- Fidelity Investments: Fidelity is a large financial services company and their website has educational content on a wide array of topics including options trading.
- Charles Schwab: Schwab’s website includes a Learning Center with a comprehensive collection of resources about investing and trading strategies.
- Options Playbook: This website is dedicated to teaching users about options trading. It includes simple explanations of call and put options, as well as more advanced strategies.
