Call and Put Options, Definitions and Examples

Descriptions of call and put options

put and call options, definition and examples
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Definition of Call and Put Options:

Call and put options are derivative investments (their price movements are based on the price movements of another financial product, called the underlying). A call option is bought if the trader expects the price of the underlying to rise within a certain time frame. A put option is bought if the trader expects the price of the underlying to fall within a certain time frame.

Put and calls can also be sold or written, which generates income, but gives up certain rights to the buyer of the option.

Breaking Down the Call Option

A Call is an options contract that gives the buyer the right to buy the underlying asset at the strike price at any time up to the expiration date (US style options).

The strike price is the price at which an option buyer can buy the underlying asset. For example, a stock call option with a strike price of 10 means the option buyer can use the option to buy that stock at $10 before the option expires.

Options expirations vary, and can have short-term or long-term expiries. It is only worthwhile for the call buyer to exercise their option, and force the call seller to give them the stock at the strike price, if the current price of the underlying is above the strike price. For example, if the stock is trading at $9 on the stock market, it is not worthwhile for the call option buyer to exercise their option to buy the stock at $10, because they can buy it for a lower price ($9) on the stock market.

 

The call buyer has the right to buy a stock at the strike price for a set amount of time. If the price of underlying moves above the strike price, the option will be worth money (has intrinsic value). The trader can sell the option for a profit (this is what most calls buyers do), or exercise the option at expiry (receive the shares).

For these rights the call buyer pays a "premium".

The call seller/writer of the option receives the premium. Writing call options is a way to generate income. The income from writing a call option is limited to the premium received though, while a call buyer has unlimited profit potential.

One call option represents 100 shares, or a specific amount of the underlying asset. Call prices are typically quoted per share. Therefore, to calculate how much buying a call option will cost, take the price of the option and multiply it by 100 (for stock options). 

Call options can be In the Money, or Out of the Money. In the Money means the underlying asset price is above the call strike price. Out of the Money means the underlying asset price is below the call strike price. When you buy a call option you can buy it In, At, or Out of the money. At the money means the strike price and underlying asset price are the same. Your premium will be larger for an In the Money option (because it already has intrinsic value), while your premium will be lower for Out of the Money call options.

Breaking Down the Put Option

A Put is an options contract that gives the buyer the right to sell the underlying asset at the strike price at any time up to the expiration date (US style options).

The strike price is the price at which an option buyer can sell the underlying asset. For example, a stock put option with a strike price of 10 means the put option buyer can use the option to sell that stock at $10 before the option expires.

It is only worthwhile for the put buyer to exercise their option, and force the put seller to give them the stock at the strike price, if the current price of the underlying is below the strike price. For example, if the stock is trading at $11 on the stock market, it is not worthwhile for the put option buyer to exercise their option to sell the stock at $10, because they can sell it for a higher price ($11) on the stock market. 

The put buyer has the right to sell a stock at the strike price for a set amount of time. If the price of underlying moves below the strike price, the option will be worth money. The trader can sell the option for a profit (what most put buyers do), or exercise the option at expiry (sell the physical shares). For these rights the put buyer pays a "premium".

The put seller/writer receives the premium. Writing put options is a way to generate income. The income from writing a put option is limited to the premium received though, while a put buyer's maximum profit potential occurs if the stock goes to zero. 

One put option represents 100 shares, or a specific amount of the underlying asset. Put prices are typically quoted per share. Therefore, to calculate how much buying a put option will cost, take the price of the option and multiply it by 100 (for stock options). 

Put options can be In the Money, or Out of the Money. In the Money means the underlying asset price is below the put strike price. Out of the Money means the underlying asset price is above the put strike price. When you buy a put option you can buy it In, At, or Out of the money. Your premium will be larger for an In the Money option (because it already has intrinsic value), while your premium will be lower for Out of the Money put options.

Other Things to Know About Puts and Calls

The pricing of options is rather complex, because the price (premium) of the option is based on many factors, including how far in or out of the money it is, the volatility of the underlying asset and how far the option is from expiration. These option pricing inputs are called the 'Greeks', and they are worth studying before delving into options trading.

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