What are puts and calls? Investors can learn the basics, the differences, and how to determine if these options are suitable for their risk level and objectives.
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- Understanding the difference between calls and puts
- Learn the rights and obligations of buying and selling call and put options
- Understand the risk and reward profiles of long and short call and put option positions
Options give traders options. But options aren’t just for traders. Qualified investors can also trade options. Investors can use options to manage risk and potentially increase returns. However, the option can carry significant risks and may not be suitable for everyone.
Options are typically used to speculate on market direction, hedge against market declines, or pursue additional income targets. This is why many active traders add them to their strategy toolbox.
First, the basics. There are two types of options: calls and puts. Each has advantages and risks, depending on whether you are a buyer or a seller.
What are calls and puts?
A call is an option that gives the trader the right, rather than the obligation, to purchase the “underlying” asset such as a stock or index.So when buying call options, the trader has the right to buy the underlying stock or index. When selling a call option, the trader is obligated to supply the underlying asset if the call he contract is assigned (more on this later).
So what is a put?Ah add an option Gives the trader the right to sell the underlying stock or index. The put buyer acquires the right to sell the underlying stock or index, while the put seller has the obligation to purchase the underlying asset if the put her option is assigned.
Let’s see how to buy call and put options. Let’s start with a call.
Buying Calls: A Coupon Analogy
Suppose a trader is interested in buying a stock, but for some reason does not want to buy it outright. Instead of buying shares, you might consider buying call options. This allows the specified price (attack price). Therefore, they can “control” a certain number of shares without owning them. This gives you the potential to make a profit (or lose) if the stock moves. If the stock price falls, stays the same, or doesn’t rise much, the trader may suffer a loss on top of the amount paid for the call option (premium) and transaction costs.
Therefore, before trading options, a trader should consider the number of contracts to be traded, the expiration date, the strike price, and the cost (premium) of the contract. You can access all of this from option chain On the thinkorswim® platform (see Figure 1).
Buying a call option is like buying a discount coupon. Let’s say you paid $25 for a coupon that entitles you to a $50 Kobe beef steak dinner. However, new trade restrictions and tariffs on wagyu beef have recently raised the regular price of a dinner to $55. Coupons are inherently more valuable. You are entitled to the same steak dinner but the value has increased by $5 from $50 to $55. This opens up some options. Let’s say your brother-in-law is interested in using a coupon for a date night and he offers $30 for your coupon. Keep or sell? If you keep the coupon, you risk losing the entire $25 you paid.
For example, imagine a massive influx of Kobe beef into the United States. Steak dinner prices dropped because beef was in high supply, and the restaurant offers the same steak dinner for him for $20. The coupon is currently worthless because the price of dinner on the open market is less than what we paid for the coupon.
Like dinner coupons, option contracts derive their value from the underlying asset. As such, options are included in a subset of financial instruments called derivatives.
The coupon example shows that buying calls is a bullish strategy, as you may profit if the underlying commodity rises in value. If traders are bullish on stocks, they can choose to buy calls. However, call options depreciate in value over time. Almost every day, the time value of an option shrinks until it expires (the Greek word “theta” measures this erosion). At that point, the option is worth the difference between the stock price and the option’s strike price. A call option can be valuable if the stock price is above the call strike price or worthless if the stock price is below the call strike price.
what to do if you decide sell call?
As a call option seller, the trader is bearish or at least neutral on the underlying stock.
However, depending on the call options sold, traders need not be extremely bearish. In fact, they can be relatively neutral. Remember when I said that the time value of options depreciates? As phone sellers, depreciation can be to their benefit. If the owner sells the stock a call that obliges him to deliver at $50, he will not have to deliver the stock as long as the stock is below $50. This agreed price is the strike price. This is the price at which the trade was “not exercised”. However, traders can still be allocated at any time even if the stock price is below the strike price.
It is also important to consider whether the trader already owns the underlying stock. If so, it’s called a “covered call” and, if assigned, requires traders to sell their shares at the strike price. If they don’t own the stock (called a “naked call”) and it is transferred, resulting in a short his position in the stock, they will have to buy back the stock on the open market to close the position. . It can also be considered to be held as a short position.
You receive credit when you sell a call option. This credit is what the trader keeps no matter what happens.But this doesn’t mean they will profit Whatever happens. If the share price exceeds the strike price, they are obliged to deliver the shares at the strike price. If you don’t own the stock, you should buy it at a higher (current market) price or hold a short position in the stock. And since stocks could, in theory, rise forever, there is infinite risk in this strategy.
If the trader has the stock in his account (a “covered call”), he has missed the price movement above the strike price. Under normal circumstances, they may try to buy back the option or roll it back to another strike or delivery month. This can result in less profit or loss than credit and incurs additional transaction costs.
Therefore, remember that if the trader is bullish, he can buy the call. If they are bearish or neutral, they can sell the call. The buyer has the right to buy the stock and the seller has the obligation to sell the stock. Finally, remember that options depreciate in value over time. This benefits the seller, but can hurt the buyer.
Buying and selling put options
Suppose a trader owns a stock and believes that the price of that stock will fall. They can buy puts that lock in the selling price for a limited time. A put allows a trader to sell a stock at a set price (the strike price) so that if the stock price falls, the put contract can be exercised. If they don’t own the stock, buying puts is more speculative in nature and is usually based on the expectation that the stock price will fall. If the underlying stock price falls, the value of the put increases. But remember that the time value of calls and puts decreases over time. And when the stock price rises, the value of the put usually falls.
Traders are bullish when selling puts. Of course, it can go from bullish to neutral depending on which strike price you choose. Some traders may simply hope that the stock price stays above the strike price, causing the put to depreciate and eventually become worthless.
If the underlying stock price falls below the strike price, they will probably have to buy the stock at the strike price. This can require a significant amount of money. If it’s a stock they want to own, selling a put could be one way to try to buy it at a lower price than the current market while still generating credit. You must ensure that you have sufficient funds in your account to cover and maintain Also, remember that the stock price will continue to fall and you may incur losses.
4 main option strategies
An option contract that gives the buyer the right to sell shares at a specified price (strike price) on or before a specified date (expiry date). For illustration purposes only.
An option contract that obliges the seller to purchase shares at a specified price (strike price) on or before a specified date (expiration date). For illustration purposes only.