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Beginner’s Guide to Options: Calls vs Puts

Caution – I am not an expert in finance or investment. Merely an enthusiast who enjoys learning.
This article should not be construed as investment advice. Writing this helps me keep all the terms straight.

What are Options?

An option is a contract providing the right to buy or sell a financial asset, at a specified price and by a specified date. The investor pays a fee, or premium, to purchase the option contract.

Options come with no obligation. An investor may decide not to buy or sell the asset, and let the option expire. The premium is not refunded, and becomes a loss for the investor.

Remember – purchasing an option does not inherently grant ownership of the underlying asset. Options provide the right to buy or sell that asset.

Two types of options exist:

  • A call option represents the right to buy an asset at a specific price
  • A put option represents the right to sell an asset at a specific price

In both cases, the contract will have an expiration (or exercise) date. The price set within the contract is known as the strike price.

Options exist for a variety of financial assets, including securities (such as stocks and bonds). Options themselves are a derivative security. The value of an option is tied to the value of the underling asset. For a broader overview on securities, check out: Investing Basics: Equity vs Debt.

Options are traded on options markets. The options market is typically separate from the primary market, which trades the underlying asset itself.

An option transaction will have a buyer and a seller. Both sides of the transaction have different risks and benefits. Let’s look at both perspectives, using call options and a fictional stock for the examples.

Call OptioNS – Buyer’s Perspective

Let’s assume an investor is optimistic about Company XYZ. The investor has a couple choices.

Choice 1: The investor can outright purchase XYZ stock, a typical investment strategy. Money to purchase the stock is paid upfront. The value of the stock will go up or down based on market conditions, company performance, and random hysteria. The investor will realize that profit or loss when they sell the stock.

Choice 2: The investor can purchase a call option with the right to purchase XYZ stock at a specific price. A premium is paid to purchase the option. No other money is paid upfront. The investor can choose to exercise the option at some point, paying to purchase the stock at the specific price. The investor would then fully own the stock (like in Choice 1). Otherwise, the investor can choose to let the option expire.

The call option provides some risk management. The most the investor can lose is the premium, if they choose not to exercise the option. The potential for profit is theoretically unlimited.

Let’s quantify this pretend example. Stock XYZ currently trades at $20 per share. A call option is available with the following terms:

  • Strike price of $25
  • 100 total shares
  • Expiration date in 3 months
  • Premium (or fee) of $1 per share

The total premium is $100 (100 shares x $1 fee per share). This represents the worst case loss for the investor, if they do not exercise the option.

Let’s look at three scenarios on how this can play out:

SCENARIO 1: If the stock price reaches $26, the investor will break even if they exercise the call option ($25 strike price + $1 fee per share).

SCENARIO 2: If the stock price moves higher than $26, the investor will likely exercise the call option. At this point, the investor owns the stock, and can sell it for a profit. The higher the stock price over $26, the higher the profit. Upside is theoretically unlimited.

(Note: because the investor now owns the stock, they are fully subject to future price volatility – both up or down.)

SCENARIO 3: If the stock price moves lower, or never exceeds $26 by the expiration date, the investor will not exercise the option. Remember, options come with no obligation for the buyer. In this example, the investor is only out the $100 premium. This remains true even if the stock price went to $0.

The investor purchasing a call option is betting the stock will go up. The cost of the bet is the premium. While the risk is contained to the premium, an investor must still make the correct bets. A series of incorrect bets will lead to accumulating losses. Predicting the market is very difficult, even for experts.

Complicating this further – terms of a call option are set by the seller, not the buyer. Calculating the potential value of an option often requires more expertise than simply investing in the stock.

Call OptioNs – Seller’s Perspective

An investor or entity selling a call option is betting the stock will go down or stay stagnant. The buyer will not exercise the option, and the seller profits on the premium. Like the buyer, the seller is trying to make winning bets. Because the seller sets the terms of the call option, they own greater control over the bet.

However, the seller potentially faces more risk than the buyer. If the buyer exercises the option, the seller is contractually obligated to sell the stock to the buyer for the strike price.

A stock’s price can fluctuate significantly. The extent of potential losses depends on whether the seller already owns the underlying stock. Let’s look at two scenarios:

SCENARIO 1: Seller already owns the underlying stock
Otherwise known as a covered call. In this scenario, a seller’s overall losses can never exceed what they originally paid for the stock, and is partially hedged by the premium. This hedge is valuable, and one reason a seller will offer a covered call.

Let’s look at an example:

  • The seller originally purchased stock XYZ for $20 a share
  • The seller offers a call option with a strike price of $25 and a premium of $1 per share
  • The stock hits hard times, and now trades at $10

The buyer naturally lets the option expire. The seller holds an overall loss of $9 a share:

$10 current price – $20 purchase price + $1 premium

Without the premium, the loss would have been $10 a share. Because the buyer let the option expire, the seller can hold the shares hoping the stock price rises again.

What if stock XYZ goes above the strike price? Will the seller see a loss? Not technically – but the seller still made a bad bet.

Let’s revisit the example above. Assume now though that stock XYZ trades for $30. The buyer gleefully exercises the option. The seller is obligated to sell the stock to the buyer for $25 a share. The seller still makes a profit of $6 per share:

$25 strike price – $20 purchase price + $1 premium

However, the seller sold the stock at below market prices, and missed a potential $10 per share profit ($30 current price – $20 purchase price). The seller did not maximize their profits, and will be unhappy with their bet.

SCENARIO 2: Seller does not own the underling stock
Otherwise known as an uncovered or naked call. In this scenario, a seller risks much higher potential losses. If a stock’s price skyrockets and the buyer exercises the option, the seller must purchase the stock at market prices to cover the call.

A seller must be supremely confident that the stock price will not rise. The seller is hoping to make a profit without investing upfront in the underlying stock. However, the upside of an uncovered call is limited to the premium. The downside is theoretically unlimited.

Let’s look at an example:

  • The seller does not own the underlying XYZ stock
  • The seller offers a call option with a strike price of $25 and a premium of $1 per share
  • The stock skyrockets to $40 per share

The buyer exercises the option. The seller must purchase stock XYZ for market price ($40), and sell the stock to the buyer for $25. Total loss for the seller is $14 per share:

$25 strike price – $40 market price + $1 premium

The buyer is ecstatic, and the seller is devastated. Even the premium hedge barely blunts the loss for the seller.

Remember, uncovered calls carry enormous risk with limited upside. Beginner investors beware.

Put Options

Put options are the opposite of call options. Puts give a buyer the right to sell an asset at a specified strike price. Buyers are still charged a premium. The put option will still expire on a specific date.

The expectations of buyers and sellers are essentially reversed with put options compared to call options. Buyers want (or are hedging against) the underlying asset to decrease in price. Sellers want the asset to increase in price or stay stagnant. Sellers still make their profit on the premium.

Let’s look at two applications of put options:

Scenario 1: Put options as a hedge
Buyers may purchase a put option as a hedge against a stock they own. This is known as a protective put. While the buyer still hopes the stock price increases, the put option protects against losses if the stock goes down.

Let’s look at an example:

  • A buyer purchased 100 shares of XYZ stock for $20 a share
  • The buyer also purchases a put option of 100 shares, with a $15 strike price
  • The premium is $1 per share, or $100 total

Until the put option’s expiration, the buyer limits any potential losses to $5 per share, plus the $100 premium. Even if the stock goes to $0, the buyer can exercise the put option and sell for $15. If the stock prices increases, or never decreases to $15, the buyer can simply let the option expire.

In the example above, the buyer is technically increasing the cost basis for the XYZ stock by $1 per share (the premium). The stock will need to exceed $21 for the buyer to make a profit. The premium is essentially insurance paid to limit loss.

Scenario 2: Put options as speculation
Alternatively, a buyer can purchase a put option on stock they do not own. This is a more speculative trade, similar to shorting the stock.

Let’s look at an example:

  • A buyer does not own the underlying XYZ stock
  • The buyer purchases a put option with a strike price of $20
  • The premium is $1 per share
  • The stock price plummets to $10

The buyer will execute the put option, as the market price is lower than the strike price. In reality, the buyer is now ‘shorting’ the stock at a price of $20. The buyer can purchase stock at the market price of $10 to ‘cover’ the short, for a total profit of $9 per share:

$20 strike price – $10 market price – $1 premium

The buyer sees maximum value if the stock price reaches $0. Unlike a call option, a put option has a cap on potential gains.

If the stock price above went up to $30 instead, the buyer can simply let the put option expire. The buyer’s loss is limited to the premium of $1 per share.

Buying a put is similar to shorting a stock directly. In both cases, the buyer wants the stock price to decrease. However, shorting a stock carries much greater risk. Short sellers essentially borrow shares on margin. If the stock price goes up, a short seller must purchase the shares at market price to cover the short sale. Potential losses for a short seller are unlimited.

Closing Thoughts

Options are complex financial instruments, and not intended for novice investors. As always, be cautious and do your research. Seek professional guidance as needed.

This article serves only as an introduction, and barely scratches the surface. Future articles may dive deeper into how options are valued and priced, and the various methodologies for options investing.

I leaned heavily on Investopedia while learning about options. Here are some great links to learn more:

© 2024 Aaron Balchunas
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