What is Call Option and Put Option? – A Beginner’s Guide

Call option and put option are the two kinds of options available in the stock market. A call option is used when we expect the stock prices to increase while a put option is used when the stock prices are expected to depreciate.

Apart from it, these tools are also known as weapons of mass destruction. However, if used with utmost wit these tools can help you turn your career around!

Let’s dive right into these and learn more!

Options

An options contract is a contract that gives the buyer the right to buy an underlying asset. However, that is not an obligation. An options contract gets its value from the value of the underlying asset. It has no value of its own. The underlying asset can be a stock, currency or commodity.

The buyer has the option of keeping or canceling the option, that is buying the asset within the stipulated time period mentioned on the contract or letting the asset go.

For example, butter has no value of its own, it derives its value from milk. Thus, if the value of milk rises, the value of milk will rise as well.

Options Available

1. Call option
2. Put option

Call option

This contract gets the buyer the right but not the obligation of buying the asset at a particular price before the expiration date of the contract.

Put Option

This option gives the buyer a right, not an obligation to sell the asset at a particular price before the expiration date of the contract.

What Is a Call Option? 

Call options are a type of derivative that grants the contract holder the right, but no obligation to buy a specified quantity of an underlying asset at a pre-determined price and date. It gives investors the potential to profit from asset price appreciation without committing to buying. In the market, call options are often used for speculation and hedging.  

How Do Call Options Work? 

Call options are financial contracts that are traded on the stock exchange. A call option can be bought and sold on a variety of securities, like currencies, swaps, ETFs, etc. The call option gives the option holder the right to acquire the underlying security at a predetermined price. However, options are non-binding, meaning there is no obligation associated with them. An equity call option typically has 100 shares per contract. The option holder will exercise his right to buy 100 shares on expiration if the underlying share price appreciates.

To obtain the call option from the option seller, the buyer must pay a fee or option premium. The price determined in the contract for the shares is called the strike price. The call option holder makes a profit when the strike price of the contract is lower than the stock price in the open market on expiration. The trader’s realised profit is the difference between spot and strike prices.

A call option can be ITM (in-the-money) or OTM (out-of-the-money) depending on whether the market price is above or below the strike price of the contract and the contract’s intrinsic value. The intrinsic value of the call option represents the value to the buyer and the cost to the seller. An in-the-money contract will have both intrinsic and extrinsic value on expiration. 

How to Calculate Call Option Payoffs?

Let’s understand how the payoff of a call option is calculated. The payoff refers to the profit or loss that buyers and sellers make. The payoff of an option trade can be determined using three key variables: strike price, option premium, and expiration date. In a basic position, the losses for the buyer are limited to the premium paid. However, the profit can be unlimited. Conversely, the profit for the seller is limited to the premium received but the potential downside is unlimited.

Let’s understand with the help of an example. You purchased the call option for a ₹50 premium. The strike price of the option is ₹200. If the stock price reaches above ₹300, you will exercise your rights. 

The payoff is calculated using the formula below.

Payoff = Spot price – Strike price 

Profit =  Payoff- Premium 

If you are a seller of a call option potential for profit is limited to the premium. However, the possible loss is unlimited. The payoff and profit for a seller will look as follows:

Payoff = Spot price –  Strike price 

Profit/loss = Payoff + Premium paid 

Call Option Example

In the example below, the stocks of Reliance Industries are currently priced at 1953 INR and we have a call option of 2000 INR expiring on 31st December 2020. The contract is priced at 57.15 INR. 1 lot of Reliance shares is 505 shares.

Spot price: 1953.15 INR

Strike price: 2000 INR

Option premium: 57.15 INR

Expiry date: 31st December 2020

Lot size: 501 shares

You shall buy this contract if you believe that the stock price of reliance will increase to 2000 INR in the time to come. If that happens the seller will be obligated to pay you the premium as per the terms of the contract. However, if that doesn’t happen, then, you will lose the premium.

You can cancel the contract in this case, the reason behind this is that you can buy the stocks from the market at a cheaper rate than the seller’s rates.

What Is a Put Option? 

Put options are financial contracts that provide the holder with the right, but not the obligation, to sell a specified quantity of underlying securities, like stocks, at a predetermined price within a set time frame. Traders use put options to profit from declining asset prices or to hedge against potential losses. Put options are used for risk management and speculative purposes.

How Do Put Options Work? 

Traders use put options for hedging and speculating in a bear market when the asset price is expected to decline. The premium of a put option increases with a declining underlying stock price. Alternatively, if the stock price increases, the put option premium declines. 

Put options give the option holders the right (non-obligatory) to sell the underlying stocks when the stock price declines. In the market, traders would buy put options to safeguard against declining stock price.

How to Calculate Put Option Payoffs? 

The buyer of a put option makes a significant profit when the underlying stock price moves below the option strike price. In a nutshell, the lower the stock price moves below the option strike price, the higher the profit. But if the stock price moves upward, the buyer will let the contract expire. In this case, the loss incurred is the premium paid to the seller. 

For the put option seller, the profit is limited to the premium received. However, the possibility of downside loss is unlimited.

Put Option Example

In the above example,

Strike price: 1953.15 INR

Spot price: 1900 INR

Option premium: 46.30 INR

Expiry date: 30th December 2020

Lot size 505 shares

Options In Other Countries

1. US Options Contracts: They can be exercised at any point in time till the date of expiry.
2. European contracts: They can be exercised only on the date of expiration.

Basic Terms

1. Strike Price: Price at which buying or selling of an asset takes place before the expiration date.
2. Spot Price: Price of the asset in the stock market at the moment.
3. Options Expiry: The date on which the contract expires, is the last Thursday of the month.
4. Option Premium: The amount paid by the option buyer to the option seller at the time of buying the option.
5. Settlement: Option contracts are settled via cash in India.

Difference Between Call Option and Put Option

Call option- Expiry (Buying)

Three things can happen as the call option nears expiry-

• Market price > Strike price = In the money call option = gains
• Market Price < Strike Price = Out of Money call option = Loss
• Market Price = Strike Price = At the Money call option = Break – Even

Call option- Expiry (Selling)

When you sell a call option, three things can happen as it nears expiry-

• Market Price > Strike Price = In the Money call option = Loss
• Market Price < Strike Price = Out of Money call option = Gains
• Market Price = Strike Price = At the Money call option = Profit in the form of premium.

Put option Expiry (Buying)

When you buy a put option, three outcomes are possible-

• Market Price > Strike Price = Out of Money put option = Loss
• Market Price < Strike Price = In the Money put option = Gain
• Market Price = Strike Price = At the Money call option = Loss of premium paid.

Put Option (Selling)

When you sell a put option, three outcomes are possible-

• Market Price > Strike Price = Out of Money put option = Gains
• Market Price < Strike Price = In the Money put option = Loss
• Market Price = Strike Price = At the Money call option = Profit in the form of premium.

Risks and Rewards In The Two Options

These basics may help you understand the concepts, but navigating the market is a different process altogether. You require extensive knowledge and practice before that. So, do ensure that you weigh all the profits and risks before making an investment in the market.

FAQs:

What is call option?

A call option is a financial contract that gives the option buyer the right, but not the obligation, to buy an underlying asset (stocks, bonds, commodities, currencies, ETFs, etc.) at a predetermined price or strike price on a predetermined date (expiry date). The seller of the contract is obligated to sell the underlying asset if the buyer decides to buy it.

What is put option?

A put option gives the option holder the right, but not obligations, to sell an underlying asset at a predetermined price on a given expiry date. The option seller is obligated to buy the asset if the option holder decides to exercise the rights.

What are the differences between call option and put options?

These are the key differences between call option and put option.

Call option	Put option
It gives the buyer of the option the right, but not the obligation, to buy an underlying asset.	The put option gives the contract holder the right, not the obligation, to sell the underlying asset.
Seller of call is obligated to sell	Seller of put is obligated to buy
The value of the call increases when the underlying asset’s price increases	The value of the put option decreases when the underlying asset’s price increases
It’s an investment strategy where the asset price is expected to rise.	The put option holder expects the asset price to fall.
Potential for gain for gain unlimited.	Potential for gain is limited to the premium earned from selling.

What is riskier: call or put?

Depending on your strategy, the loss can be limited to the premium amount or result in an unlimited loss.