Exploring Put and Call Options

A good way to begin to understand options trading is by exploring put and call options, their basic mechanics, and the benefits of each relative to trading in the underlying securities. While there are clear differences between puts and calls, it will be useful to first understand a few basic principles of options. After these are understood, the details of call options and put options will be more apparent.

Option Basics

At the most basic level, an option contract gives the owner the right, but not the obligation, to transact in a specified amount of an underlying security or commodity at a set price for a set period of time. For example, an XYZ July 60 call option gives the owner the right to buy 100 shares of XYZ at $60 until the third Saturday in July; all equity options are written for 100 shares of stock, and all expire on the third Saturday of the expiration month for which they are written. In this example, $60 is called the strike price and is the price at which the contract can be exercised. Furthermore, option contracts are always a zero-sum game – for every contract, there is a buyer and a seller in the marketplace.

Call Options

Remaining with equity options, a call option gives the owner the right to buy 100 shares of the underlying stock at the strike price until expiration. Call options gives the owner similar exposure to the stock as owning the shares, but limits downside. If the stock falls precipitously, the most that the owner of a call option can lose is the premium paid for the option. The seller of a call option, however, has the potential of unlimited loss. If the price of the stock increases significantly and the option is exercised, the seller must deliver 100 shares of the stock in exchange for the strike price per share. If the seller of the option did not already own the stock (referred to as being naked), he or she must now buy the stock at the prevailing market price. Because the stock’s price can increase indefinitely, the theoretical maximum loss for the seller of the option is infinite. Call options can be used to control a long position with less capital, but creates greater risk for the seller.

Put Options

A pall option gives the owner the right to sell 100 shares of the underlying stock at the strike price until expiration. Put options gives the owner similar exposure to the stock as being short the shares, but limits downside. If the price of the stock increases drastically, the owner can only lose the amount he or she paid for the option. In some instances, an individual who is long a stock may buy a put option as a hedge against a fall in the stock’s price. If the price falls below the strike price, this investor will mitigate his or her losses because the put option will appreciate as the stock depreciates. At some point the hedge can be lifted, and the investor can return to simply being long. Both calls and puts have certain advantages and certain shortcomings; understanding these instruments can be beneficial if they are used correctly.

 

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