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

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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

  • Call option
  • 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.

Options in other countries-

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

Basic Terms

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

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.

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

Difference between the call option and the put option

Parameters Call option Put option
Definition Gives the buyer the right but not the obligation to buy Gives sellers the right but not the obligation to sell an asset.
Investor Expectation The stock prices will increase. The stock prices will fall.
Gains The gains are unlimited for the buyer. Limited gains as the stock prices cannot fall to zero.
Loss Loss is limited to the premium paid. The loss will be strike price minus the premium.
Reaction to dividend Lose value Gain value

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

Call Buyer Call Seller Put Buyer Put Seller
Maximum Profit Unlimited Premium received Strike price minus premium Premium
Maximum Loss Premium paid Unlimited Premium Paid Strike price- premium
No profit or loss Strike price + premium Strike price + premium Strike price- premium Strike price- premium
Ideal Action Exercise Expire Exercise Expire

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.