Options trading is an essential but often bemused part of the derivatives market. The options market is based on two basic contracts: Call Option and Put Option. The first step on your path to trading success is a clear understanding of the different Call Options and Put Options.
If you are new to the F&O segment, you will find it necessary to understand what Call and Put Options are as part of your option trading strategies.
Ready to start your journey? Learn more in our Stock Market Course.
What are Options?
Options are a type of financial derivative contract that grants the buyer the right, but not the obligation, to sell an underlying asset (stock, index, commodity) at a specified price (strike price) on or before a specified date (expiration date).
To obtain this right, the buyer pays the seller, or writer, a non-refundable cost called a premium, which is typically a small percentage of the underlying asset. Whereas the seller of the option essentially takes on an obligated risk that they will buy or sell an underlying asset should the buyer of the option exercise their right.
As you continue to learn how this market works, you may want to consider our guide on How to Start Trading in the Derivatives Market.
Deepen your technical knowledge: Explore the Advanced Technical Analysis Course.
What is a Call Option?
A Call Option provides the option holder the right to purchase the underlying asset at the strike price.
Call Option: Perspective of the Investor
Market outlook: A Call Option buyer has a bullish opinion. They believe the underlying asset prices will move significantly higher than the strike price before the expiration date.
The Right: The right to Buy.
Profit potential (for the Buyer): Theoretically unlimited. The higher the stock price rises, the greater the profit.
Maximum Loss (for the Buyer): The loss is limited to the premium paid.
Breakeven: Strike Price + Premium
Example: Assume you buy a Call Option on ABC stock with a strike price of $100 and a premium of $5. If the stock price then increases to $120, you are able to purchase the stock at the strike price of $100 to immediately sell it in the market for the current price of $120. Your profit would be ($120?$100)?$5 = $15. If the stock remains at $100 or it becomes lower, simply let the option expire and only lose the $5 premium.
Master the building blocks of derivatives: Check out the NISM Series VIII course.
What is a Put Option?
A Put Option provides the buyer the right to sell the underlying security at the strike price.
Put Option: Investor's Perspective
Market View: A put option buyer is moving bearish. They anticipate the price of the underlying will decline significantly below the strike price before expiration.
Right: The right to sell.
Profit Potential (Buyer): Limited. Maximum profit happens when the price of the stock goes to zero and then is limited to (Strike price - Premium).
Maximum Loss (Buyer): Limited to the premium paid.
Breakeven: Strike Price – Premium
Example: You purchase a Put Option on ABC stock with a strike price of $100 for a premium of $5. If the stock drops to $80, you are able to buy it from the market at $80 and exercise your option rights at the agreed price of $100. Your gain is ($100–($80?$5)= $15. If the stock price remains at $100 or increases, you lose the premium of $5.
Ready to elevate your trading game? Enroll in the advanced Options Trading Course.
Key Differences Between Call Option and Put Option
The principal difference in a Call Option versus a Put Option is in the rights it grants and in the market view being taken. See below for a direct comparison of the two:
It is important to understand the difference in profit and loss scenarios and profiles. Both choices provide limited risk for the buyer (maximum loss is the premium paid), which is one of the main attractions of options trading.
When to Use a Call Option and a Put Option?
Whether to select a Call Option or a Put Option is solely based on your market view and what you are specifically trying to achieve (such as speculating, hedging, or generating income).
When to Use a Call Option
Speculation (Betting on Price Rise): If you are bullish on a stock and believe there could be a decent movement upwards, a Call Option offers tremendous leverage.
Hedging Short Position: If you short a stock, buying a Call Option can serve as "insurance" against unpredictable price spikes, ultimately limiting your loss.
Generating Income (Covered Call): This theory is more advanced but quite simple in practice, as you already own the stock and now you sell (write) a Call Option to generate a premium.
Learn effective risk strategies: Check out the Risk Management Certification Course.
When to Use a Put Option
Speculation (Betting on Price Fall): If you are bearish on a stock and anticipate a price drop, a Put Option gives you the opportunity to profit from the decline.
Protective Put (Hedging a Long Position): This is one of the most fundamental and useful ways to use options. If you own a stock, and you do not want to own it much longer because you fear it will drop in the short term, you could buy a Put Option to hedge against a downside risk in your portfolio. This idea is at the heart of risk management concepts in the stock market.
Generating Income (Cash-Secured Put): You could sell (write) a Put Option when you are moderately bullish and you are willing to buy the stock at the strike price if it declines.
For those interested in learning more about hedging and risk, please see our blog article on What is Hedging in Derivatives?
Conclusion
The Call Option and Put Option are the two building blocks of the derivatives market. The Call Option gives the right to buy, suited for a bullish view, while the Put Option gives the right to sell, suited for a bearish view. Both Options allow the buyer to have limited risk, making options an effective way to speculate and, importantly, an effective way to manage risk.
.jpg)
