What Is a Call and Put Option? A Simple Explanation

Financial options are sophisticated financial instruments known as derivatives, meaning their value is derived from an underlying asset. These contracts provide the holder with the right, but not the obligation, to buy or sell that underlying asset at a predetermined price on or before a specified date. Options serve various purposes, including speculation on market movements or managing investment risk. This article details two primary types: call options and put options.

Core Components of Options

Understanding the basic elements of an options contract is important for comprehending how they function. Every option, whether a call or a put, is built upon standardized components that dictate its terms and value. These components define the specifics of the agreement between the buyer and the seller.

The “underlying asset” is the financial instrument upon which the option contract is based. This could be a stock, an exchange-traded fund (ETF), a commodity like gold or oil, or even a currency. The value of the option directly correlates with the price movements of this underlying asset.

The “strike price,” also known as the exercise price, is the fixed price at which the underlying asset can be bought or sold if the option holder chooses to exercise their right. This price is set when the contract is created and remains constant throughout the option’s life. The difference between the strike price and the current market price of the underlying asset significantly influences an option’s profitability.

The “expiration date” marks the final day on which the option contract can be exercised. If the option is not exercised by this date, it expires worthless, and the holder loses the money paid for the contract. Options have expiration dates ranging from a few days to several years.

The “premium” is the price the option buyer pays to the option seller for the rights conveyed by the contract. The premium is influenced by factors including the underlying asset’s price, the strike price, the time remaining until expiration, and the volatility of the underlying asset.

Understanding Call Options

A call option grants the holder the right, but not the obligation, to buy an underlying asset at a specified strike price on or before the expiration date. Buyers of call options anticipate that the price of the underlying asset will increase above the strike price. Potential profit is theoretically unlimited as the underlying asset’s price can rise substantially.

For example, if a trader buys a call option on XYZ stock with a strike price of $50 and an expiration in three months, paying a premium of $3 per share, the breakeven price is $53. Each option contract represents 100 shares, so the total cost for one contract would be $300 ($3 premium x 100 shares).

If XYZ stock rises to $60 per share by the expiration date, the buyer can exercise their right to purchase 100 shares at the $50 strike price. They could then immediately sell these shares in the market at $60, realizing a gross profit of $10 per share ($60 market price – $50 strike price). After accounting for the $3 per share premium paid, the net profit would be $7 per share, totaling $700 for the contract ($7 x 100 shares).

Conversely, the seller of a call option receives the premium and assumes the obligation to sell the underlying asset at the strike price if exercised. Call sellers typically have a neutral to bearish outlook, expecting the price to remain below the strike price or decline. Maximum profit is limited to the premium received.

If, in the previous example, XYZ stock remains below $50 per share at expiration, the call option buyer would not exercise their right, as they could buy the shares for less in the open market. In this scenario, the option expires worthless, and the call seller retains the entire $300 premium as profit. However, if XYZ’s price rose significantly, the seller would be obligated to sell shares at $50, potentially incurring substantial losses if they did not already own the shares.

Understanding Put Options

A put option provides the holder with the right, but not the obligation, to sell an underlying asset at a specified strike price on or before the expiration date. Buyers of put options expect the price of the underlying asset to fall below the strike price. This allows them to profit from a decline in value or protect existing holdings.

For instance, if an investor buys a put option on ABC stock with a strike price of $100 and an expiration in two months, paying a premium of $5 per share, the breakeven price is $95. For one contract representing 100 shares, the total cost would be $500 ($5 premium x 100 shares).

Should ABC stock decline to $85 per share by expiration, the buyer can exercise their right to sell 100 shares at the $100 strike price. They could acquire these shares from the open market at $85 and immediately sell them to the put option seller for $100, generating a gross profit of $15 per share ($100 strike price – $85 market price). After deducting the $5 per share premium, the net profit would be $10 per share, amounting to $1,000 for the contract ($10 x 100 shares).

The seller of a put option receives the premium and assumes the obligation to buy the underlying asset at the strike price if exercised. Put sellers typically hold a neutral to bullish view, believing the price will remain above the strike price or increase. Maximum profit is limited to the premium collected.

In the example above, if ABC stock stays above $100 per share at expiration, the put option buyer would not exercise their option, as they could sell their shares for more in the open market. The option would expire worthless, allowing the put seller to keep the full $500 premium. However, if ABC’s price fell significantly, the seller would be required to purchase shares at $100, potentially leading to losses if the market value of those shares is considerably lower.

Distinguishing Calls from Puts

Call and put options serve distinct purposes in financial markets, primarily differing in the rights they grant and the market outlook they suit. The fundamental distinction lies in whether the contract provides the right to buy or the right to sell an underlying asset.

Call options grant the holder the right to buy an asset, making them suitable for investors with a bullish market view who aim to profit from upward price movements.

Conversely, put options give the holder the right to sell an asset, aligning with investors who anticipate a decrease in the underlying asset’s price. These options are employed by those with a bearish market view or as protection against declines in existing asset holdings.