If you’re interested in trading, then you’ll probably want to get familiar with put vs. call options. Getting involved with options trading can give you more flexibility and help you get involved with more complex trading strategies. Before we begin, you should know that options trading does come with significant risks. Understanding the ins and outs of put and call options can help you make better decisions to potentially increase your returns without taking on more risk than you’re comfortable with.
Call vs. Put Options: What are They?
There are 2 different kinds of options — calls and puts. You can be the buyer or the seller of either one of these options, and each level of involvement comes with its own unique amount of risk.
Call options give you the right to purchase a stock or other asset at a specific price on or before the options contract’s expiration date. You do not have to follow through and purchase the stock or other asset, but you do have to pay the premium for the call option upfront and that will not be reimbursed if you do not end up purchasing the stock. These options increase in value as stock prices rise and are popular among traders that are looking to make large profits.
Put options give you the right to sell your underlying assets at a specific price within a specific time frame. A wide range of underlying assets can be sold using put options, including stocks, indexes and currencies. The value of the put option increases as the price of the underlying asset decreases. Some investors will use put options to minimize their losses if they believe that the price of their asset might fall. Oftentimes, this strategy is used by investors as something similar to insurance to ensure that their losses don’t exceed an amount that they’re uncomfortable with.
Similarities Between Call and Put Options
Call and put options are relatively similar. Both types of options are used for similar reasons by investors. This includes:
Speculation: Investors can use market analyses to speculate on future prices. By buying a call option on an asset, the investor can have some leverage and exercise their right to purchase the asset if their speculation was correct.
Hedging: The term “hedging your bets” exists for a reason. It means to reduce your risk at a reasonable cost. Investors can use options trading as a way to insure their investments and limit risks in a cost-effective manner.
Both call and put options can be in-the-money, out of the money or at the money.
In-the-money: Essentially, an in-the-money option means that the holder of the option will benefit from the options contract. If a call option is in-the-money, this means the investor holding the option is able to buy the asset below the current market price. If a put option is in-the-money, the investor holding the option can sell the asset above the current market price.
Out-of-the-money: This is exactly what it sounds like, and is the opposite of in-the-money. An out-of-the-money call option means that the strike price is higher than the asset’s market price. An out of the money put option means that the strike price is lower than the asset’s market price.
At the money: An at the money option can be placed right in the middle. This is where the option’s strike price is exactly the same as the price of the underlying security. Call and put options can both be at the money.
How Do Call Options Work?
If you have your eye on a stock but you’re not quite ready to purchase it for some reason, you might want to buy a call option instead of buying the stock outright. Buying a call option will give you the ability to purchase 100 shares, but you won’t be obligated to follow through with the purchase. When you purchase the call option, you’re essentially buying the right to purchase the underlying asset at a specified price on or before an expiration date. You can continue to monitor the underlying asset (in this case, the stock) to see how it moves. If the asset you bought the call option on is below the strike price at the expiration date, you’ll lose the amount (the premium) that you paid for the options contract.
You can also sell a call option, which you might want to do if you have an underlying stock that you predict is going to go down. If you own the stock that you’re selling, this is called a “covered call” and requires you to sell your shares at the agreed-upon price, known as the strike price. You can also sell a call option on shares that you don’t own, which is called a “naked call.” If you do this, you’d need to buy the shares and then deliver them to the buyer of the call option.
Having options may sound straightforward and the flexibility can be appealing for some. However, it’s important to remember the limitless risks that come with call options. If you sell a call option at the strike price, but the stock has gone higher since you agreed upon the price, you may not end up profiting from the sale. This is especially true if it’s a naked call and you have to purchase the shares at a higher price before selling the call option.
How Do Put Options Work?
As a trader, you can buy a put option to help you profit from the decline of a stock’s value. You’ll have to purchase the put option, which will include a strike price and an expiration date. Some people think of purchasing put options as being similar to purchasing insurance against the decline of an asset. If the asset’s value falls below the strike price in the options contract, you can earn profit from having purchased the put option.
You can also sell a put option. This could be beneficial if you think that the asset’s value will remain the same or increase to an amount that is above the strike price. As the seller of the put option, you could benefit from the price that you sold the put option for, whereas the buyer would lose out because the option would be worthless at expiration.
In some ways, selling a put option could be considered a low-risk way to gain a profit. However, keep in mind that you’ll only profit for the amount that you sold the put option for. As with any form of trading, it does come with risks. If your speculation is incorrect, you could end up losing much more than you were hoping to gain.
Options can be valuable for any trader that is willing to take some risks with the hope of gaining a profit. However, it’s important that you understand the risks and benefits before you jump in.
If you want some help picking the most profitable options for beginners, you’re in luck. Simply subscribe to Benzinga Options to receive recommendations and insights from pro options trader Nic Chahine.
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