If you’ve only recently begun learning about options, the first step is understanding what puts and calls are. Puts and calls are fundamental in options trading, offering rights to sell or buy assets at set prices. Call and put options come with unique benefits and risks, and you should keep in mind your market outlook before applying them to your trading strategy. In this beginner-friendly guide, we’ll break down the basics of puts and calls to give you a solid foundation for your options trading strategies.
Key takeaways
- Call options offer the right, but not the obligation, to purchase an asset at a set price before expiration. Put options provide the right, but not the obligation, to sell an asset at a set price before expiration.
- When buying a call or put option, the buyer pays a premium to the seller and has unlimited profit potential vs limited loss risk. Instead, selling puts or calls generates premium income, and the seller has a limited profit potential with unlimited risk of loss.
What are Puts and Calls?
What are puts and calls and how do they function in the options market? At their core, call and put options are contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price before a specified expiration date.
Calls and Puts Explained – A Quick Historical Perspective
Historically, the concept of options can be traced back to ancient times, but options trading as we know it began to take shape in the 17th century. The Amsterdam Stock Exchange was one of the first to list options, allowing traders to speculate on future price movements. Fast forward to today, options trading has evolved significantly, with modern markets offering a vast array of strategies to accommodate different investment goals.
Understanding the components of an options contract is crucial. Each contract includes:
- Strike Price: The specified price at which the option holder can buy (call) or sell (put) the underlying asset.
- Expiration Date: The deadline by which the holder must exercise their right to buy or sell.
- Premium: The price paid for the option, giving the holder the right to the contract.
These elements combine to create a versatile financial instrument that can be used for hedging against potential losses or for speculative purposes.
When comparing Call vs Put Options, it’s important to consider their distinct roles. Call options are typically bought when an investor anticipates that the underlying asset’s price will rise. Conversely, buying put options comes into play when an investor expects a decline in the asset’s value.
In the context of hedging and speculation, these options serve significant purposes:
- Hedging: Investors use options to protect their portfolios against adverse price movements. For example, buying put options on stocks you own can act as insurance against a drop in stock prices.
- Speculation: Options provide opportunities to profit from price fluctuations without owning the underlying asset. This can lead to substantial gains, but also comes with considerable risk.
The profit and loss (P&L) profiles for long call and long put strategies highlight the potential outcomes. For instance, buying a call corresponds to this P&L profile:
These are the two aspects you should notice in the chart above:
- Potential for unlimited profit if the asset’s price rises significantly.
- Loss is limited to the premium paid if the asset’s price stays below the strike price.
What about puts? When you buy a put, this is your typical P&L:
In this case, we can highlight a couple of aspects:
- Potential for significant profit if the asset’s price falls sharply.
- Loss is limited to the premium paid if the asset’s price remains above the strike price.
Understanding what are puts and calls is essential for anyone interested in options trading. These instruments offer a range of possibilities for investors looking to manage risk or capitalize on market trends.
Buying Calls in a Bull Market – An Example
In our articles, we like giving you examples to better understand options trading. For this first example, let’s focus on buying call options in a bull market. Imagine you’re optimistic about Delta Airlines (DAL). You’ve reviewed the company’s fundamentals and discovered it has a strong score of 9 out of 10, suggesting it’s a solid stock pick.
Now, let’s look at a practical scenario. Suppose our options screener shows the chance to buy a $43.5 call option expiring in one month. This is what your P&L would look like:
DAL is currently trading at $41.38. For you to make a profit, DAL’s price needs to exceed $44.28 by the expiration date. The breakeven point of $44.28 is simply the strike price of $43.5 plus the call option premium cost.
Here’s where it gets interesting. While you need DAL’s price to hit $44.28 at expiration to profit, you could still earn money by selling your position earlier if the stock price is trending positively. This is where the green and orange lines on your profit and loss (P&L) chart come in handy:
- The green line shows your option’s P&L profile today, while the orange line indicates what it would be at expiration.
- As expiration nears, the green line shifts towards the orange line.
- Therefore, even if DAL’s price is below $44.28 before expiration, you might still secure some gains by selling sooner, following the green line’s trajectory.
Choosing the right strike price is crucial but not always straightforward. Our options screener merely highlights possibilities, not recommendations. In this scenario, the screener detected a high volume for the $43.5 call option, suggesting that “smart money” might be betting on DAL surpassing the breakeven price, though there’s no guarantee that these institutional investors are correct.
When trading options, you should always take a look at the historical price and market trends of the underlying asset before making any decisions. In the case of DAL, it’s important to note that its stock price has been above your breakeven price recently:
Past performance will never be a solid indicator of future trends, but it’s a factor to consider when evaluating the potential outcomes of your options trades. In this case, just as a reminder, this is what we observed:
- A high exchange volume on this call contract
- The fact that DAL is considered by many a solid company
- The fact that DAL has been trading above the breakeven price for a while over the past few months
If you combine these elements, you could tell yourself that this looks like a more than decent trade idea.
A Real-Life Example of Buying Puts in a Bear Market
We showed you a long call example above, so let’s now do the same for a long put trade, another simple options strategy you may want to consider. Imagine you’re bearish on Marathon Digital (MARA). After reviewing its fundamentals, you believe the stock is overvalued. Our options screener supports this view, showing MARA with a fundamental score of only 3 out of 10, a low value suggesting potential downside.
Consider that MARA is trading at $18.69. In this scenario, the options screener may highlight the opportunity of buying a $17.5 put option expiring in one month.
Your P&L profile would look as follows:
Note that you would need the stock price to drop below $16.11 by expiration to secure a profit. The $16.11 breakeven point is calculated by subtracting the put option premium from the $17.5 strike price.
Just as with the call options example, your P&L chart includes green and orange lines. The green line shows your put option’s current P&L profile, while the orange line represents its position at expiration. As the expiration date approaches, the green line aligns more closely with the orange. Thus, even if MARA’s price doesn’t fall below $16.11 before expiration, you could still profit by selling your position earlier, following the green line’s path.
Selecting the correct strike price for your long put strategy can be challenging, just like we told you in the previous example on the call trade. In this case, the scanner found a high trading volume on this specific put option, which suggests that “smart money” might be betting on MARA declining past the breakeven price, although institutional investors aren’t always correct.
Additionally, consider MARA’s historical price behavior. The stock has a pattern of revisiting the $15 threshold, as you can see below:
If you anticipate this recurring event, your long put strategy could prove profitable.
Would you take this trade? Well, here’s what you could have noticed during your analysis:
- Significant trading volume on this put contract
- MARA’s negative fundamentals may suggest a potential decline in stock price
- MARA has frequently dropped below the breakeven price in the past few months. This may mean that investors are not particularly confident in the stock’s long-term stability above $15.
Putting these factors together, it appears to be a promising trade idea. Being well-acquainted with what are puts and calls is key to executing successful options trades. This real-life example gives you a general idea of how put options can be effectively used in a bearish market scenario, enabling you to capitalize on anticipated stock price declines while managing risk.
Call vs Puts – Pros and Cons
As you may guess, both calls and puts have pros and cons that you should consider when trading options. Here is a table summarizing the pros and cons of buying calls for you:
Pros of Call Options:
- Profit Potential: Call options provide investors with the opportunity to gain from substantial increases in the price of an underlying asset. When the market price exceeds the strike price by a significant margin, the profit potential can be substantial, offering returns that exceed the initial investment.
- Limited Loss: The maximum loss on a call option is confined to the premium paid, making it a less risky investment compared to purchasing stocks directly. This limited downside allows investors to speculate on asset prices without committing large amounts of capital.
- Leverage: Call options allow investors to control a large position with a relatively small initial investment. This leverage can amplify returns on investment, enabling traders to gain significant exposure to an asset for a fraction of the cost of owning the asset outright.
Cons of Call Options:
- Time Decay: One of the main challenges with the strategy of buying call options is time decay, where the option’s value decreases as the expiration date approaches. This is particularly problematic if the underlying asset’s price remains stagnant or does not rise sufficiently to offset the loss of time value.
- Downward Market Volatility: Sudden and unpredictable market drops will negatively impact the profitability of a call option. High volatility can make it difficult to predict price movements, increasing the risk of the option expiring worthless.
- No Upside in Sideways Markets: Call options derive their value from upward price movements. In a market where the asset’s price moves sideways, the call option may expire without any value, causing the investor who bought the call to lose the entire premium paid. And even if you are above your breakeven price before expiration, the sideways movement will reduce your profit.
And what about put options? Here is a table with the main advantages and disadvantages of buying puts:
Pros of Put Options:
- Hedging: Put options are a powerful tool for hedging, allowing investors to protect their portfolios from declines in asset values. By purchasing puts, investors can offset potential losses from their holdings, preserving capital during downturns.
- Profit in Bear Markets: Put options enable investors to profit from falling asset prices. They provide an opportunity to gain during bear markets or when specific stocks are expected to decline in value, diversifying strategies and expanding opportunities for profit.
- Limited Risk: As with call options, the risk associated with put options is limited to the premium paid. This limited risk profile makes puts an attractive choice for managing downside exposure without committing large sums of capital.
Cons of Put Options:
- Cost of Insurance: Utilizing puts as a hedging strategy can be akin to purchasing insurance, which may become expensive if not managed strategically. The cost of premiums can add up, particularly if the protective position is maintained over extended periods without yielding beneficial price movements.
- Expiration Pressure: Similar to calls, put options face the challenge of expiration pressure, where the option value diminishes as the expiration date nears. Without a significant price drop in the underlying asset, the put may lose its value.
- No Benefit in Stagnant Markets: If the underlying asset’s price remains stable, put options will likely expire worthless. This lack of significant price change results in a total loss of the premium paid, underscoring the importance of accurate market predictions when utilizing puts.
Selling Calls and Puts Explained
As a last point to consider, we should tell you more about what happens on the other side of the market. We told you all the basics about buying options, but what about selling? That’s right, just like stocks, you can also short sell options. This approach is different from buying and involves selling call and put options to earn premiums.
Selling Call Options
When you sell a call option, you agree to potentially sell shares of an underlying asset at a set price (strike price) if the buyer chooses to exercise the option.
The main advantage here is the premium income you receive upfront. This strategy can be particularly advantageous if you predict that the stock price will remain below the strike price, allowing you to keep the premium without selling the shares.
Selling Put Options
Selling put options involves agreeing to purchase the underlying stock at the strike price if the option is exercised.
This strategy can be attractive if you want to acquire stocks at a lower price than the current market value. It’s often used when you believe the stock price will not drop below the strike price.
The P&L Profiles of Selling Call and Put Options
This is the typical P&L profile you’d have when selling a call option:
Note that:
- Your profit would be capped at the premium received if the stock price never exceeds the strike price.
- Your potential losses would be unlimited if the stock price rises significantly above the strike price.
And this is what your P&L profile would look like when selling a put option:
In this case, you should consider that:
- Your profit would be capped at the premium received if the stock price remains above the strike price.
- Your potential losses would increase exponentially as the stock price decreases below the strike price.
Therefore, selling call and put options may look like a higher-probability strategy, mainly because time is on your side: you don’t need the stock to swing in your favor as long as it stays below (in the case of calls) or above (in the case of puts) a certain price. However, this higher probability comes with a trade-off: the limited profit potential and potentially unlimited losses.
