Difference Between Call and Put Options With Examples

In our previous chapter, we covered what a derivative means in depth. In this chapter, we shall dive deeper into one of the most popular derivative types: Options. Options are a derivative type and enjoy high popularity among traders for their sheer profit-making potential. 

In this chapter, we will also cover options, their types, the difference between their types and the whole risk-reward situation associated with options. 

Let’s get started.

What Are Options in Trading?

Options are derivatives that give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (strike price) and date. You may simply think of options as a contract wherein you have the right but not the obligation to buy or sell an underlying asset, which could be anything — stocks, currencies, or commodities. But, unlike futures and forward contracts, options buyers and sellers are not obligated to honour their contracts.

You should also note this about options – They do not involve ownership of the asset in concern. Like, when you purchase a stock, you gain ownership of the same. However, in options, you pay a premium to trade the asset for profit and no more. 

Before we explore the intricacies of options, let’s learn a few common terms associated with the options world. These terms will also help you understand and appreciate this chapter better. 

• Strike price: The strike price, also known as the exercise price, is the predetermined price (agreed upon by both seller and buyer) at which the underlying asset can be bought or sold when exercising an option.
• Underlying price: The underlying price refers to the current market price of the asset on which the option is based. It quite literally is just the asset’s spot price. 
• Exercising of an option contract: Exercising an opinion contract involves utilising the right to buy or sell the underlying asset at the pre-agreed strike price.
• Option expiry: Option expiry is the date on which an option contract becomes invalid or expires. After this date, the option can no longer be exercised. In India, equity futures and options expire on the last Thursday of each month.
• Option premium: The option premium is the price paid by the buyer (holder) to the seller (writer) of an option contract. It represents the cost of acquiring the option and varies based on several factors, such as the underlying asset’s price, volatility, time of expiry, and market conditions.
• Option settlement: Option settlement refers to the process of concluding an options contract. Option settlement in India is cash-based. 

Now that we are beyond the basic terminology, note that options are of two main types – American and European. 

American options allow the holder to exercise the option at any time before the option’s expiration date. This provides flexibility, as the holder can choose the optimal time to exercise their option based on market conditions. European options, on the other hand, can only be exercised at the expiration date. 

In India, all option contracts are European in nature. This means that the options can only be exercised on the expiration date. 

Types of Options in Trading

We have already covered in detail above what an option means. Now, let’s move to the types of options. These are of two types – 

• Call options
• Put options 

We’ll first explore the call options. 

• Call Option

A call option gives the buyer the right but not the obligation to buy an asset (assume stock in our case) at a predetermined rate and date. You can buy a call option if you are bullish on a stock or assume that the price will rise soon. On the other hand, you can write or sell a call option if you anticipate a price fall. 

Let’s take an example to understand call options better. Suppose there is a call option available for ITC with the following details. 

• Underlying asset: ITC Limited (stock)
• Strike Price: Rs. 250
• Expiry Date: 30th April 2024
• Premium: Rs. 8 
• Market Lot: 1000 shares

Now, let’s say Trader X wants to buy this call option (option buyer), and Trader Y wants to sell (write) this call option. Trader X, the buyer, then pays the premium of Trader Y. Since the market lot is 1000 shares, the total premium paid by Trader X is –

=1000*8 = Rs. 8,000

By paying this Rs. 8,000, trader X has acquired the right to buy the shares of ITC at the pre-agreed price (i.e. Rs. 250). Now, on 30th April 2024, if the spot price of ITC is higher than Rs. 250, trader X would exercise the option. Let us assume on this date, the ITC is trading at Rs. 285. 

Now, trader X, exercising his right, buys 1000 shares of ITC at Rs. 250, even though the share price of ITC in the spot market is Rs. 285. That’s a neat profit of Rs. 35 per share. So, the profit on 1000 shares would be 

= 1000*35 = 35,000.  

However, the buyer, i.e. Trader X, did pay a premium of Rs. 8,000; therefore, the net profit is 

= Rs. 35,000 - Rs. 8,000 = Rs. 27,000. 

In the above example, by just paying a premium of Rs. 8000, trader X enjoys a net profit of Rs. 27,000. That is a massive 337.5% ROI! Do you understand the profit potential of options?

In the above scenario, the call option buyer makes a net profit of Rs. 27,000. But what about the call option seller? What is P/L from the whole exchange? 

Difference in Payoffs for a Call Option Buyer and Seller

A call option limits the buyer's loss to the premium paid only. However, the registered profits may be unlimited. However, for a call option seller, the profit is limited to only the premium received (in this case, Rs. 8,000). However, losses can be unlimited. Imagine a situation where, in the above example, the spot price rises to Rs. 390, Rs. 400, or Rs. 420. You cannot predict how high the stock price may go. 

Also, note this – If the spot price is equal to or falls below the strike price, the buyer of a call option will lose money (only limited to the premium paid).

Now that you understand the call option from a seller and buyer's perspective let’s move to the next option type – Puts. 

• Put Options

A put option gives the buyer the right but not the obligation to sell an asset at a predetermined rate and date. It can be bought if you are bearish on a stock or assume that the price will fall soon. You can sell a put option if you are bullish on a stock. 

Now that you understand call options, here is a simple trick to understand put options – The entire premise and P/L situation will be the exact opposite of a call option. 

Let’s take the same example as given below, but we shall reverse the situation here. Trader X anticipates a price fall in ITC and buys a put option by paying a premium of Rs. 8 for a market lot of 1000 shares. The put seller, on the other hand, anticipates a price rise and pockets the Rs. 8000 premium. 

Having paid the premium, Trader X has secured the right to sell the ITC stock at Rs. 250. Now, if on 30th April 2024, the ITC share falls to Rs. 220, Trader X can exercise his right to sell the share at Rs. 250, even though the spot price is Rs. 220. If you do the math, Trader X has made a profit of Rs. 30,000 ((250-220)*1000), and the net profit is Rs. 22,000. 

But what about the put option seller? Read below. 

Difference in Payoffs for a Put Option Buyer and Seller

The put option seller’s losses here will be unlimited. You cannot predict how far the stock will fall, can you? The put option buyer’s loss, however, is limited only to the premium paid. Furthermore, the put option buyer's profit potential is unlimited, while that of the seller is capped at Rs. 8000. 

Do you now understand the whole functioning of call options and put options? 

Risk & Rewards Related to Options

You must have observed how risk and rewards play out in options, and that is why it is important to formulate the right strategies to manage risk and manage investments. 

One of the key benefits of options (and the reason for their high popularity) is their potential to generate high returns. Options provide investors with leverage, allowing them to control a large position in the underlying asset for a fraction of the cost. This means that even a small price movement in the underlying asset can result in significant profits for options holders.

However, it is important to recognise that with higher returns come higher risks. Options are known for their time decay, which means that as the expiration date approaches, the option’s value may decline rapidly. This time decay can erode an option’s value, resulting in losses for the holders if the underlying asset does not move in the desired direction. 

Other risks involved in option trading include market risks such as volatility and liquidity. Volatility can significantly impact the value of options, as higher volatility generally leads to higher option premiums. Illiquid options markets can pose challenges in executing trades at desired prices, potentially resulting in slippage and higher transaction costs. 

Now, to mitigate these risks, it is essential for options traders to conduct thorough research, develop a solid trading plan and employ risk management strategies. This may include diversifying the options portfolio, setting predetermined profit targets and stop-loss levels, and using risk-reducing strategies like hedging. 

This concludes the chapter on options. We hope that the options and their types are now clear. In the next chapters, we will explore derivatives and their types further.