What Is a Call and Put Option in Finance?

Financial options are a type of financial contract that derive their value from an underlying asset, such as a stock, commodity, or index. These contracts provide the holder with a right, but not an obligation, to engage in a transaction involving that underlying asset at a predetermined price. Options are standardized and traded on regulated exchanges, operating under the oversight of bodies like the Securities and Exchange Commission (SEC) for stock options and the Commodity Futures Trading Commission (CFTC) for commodity or futures options. The buyer of an option pays a fee for this right, known as the premium.

What is a Call Option?

A call option is a financial contract that grants the buyer the right, but not the obligation, to purchase an underlying asset at a specific price, known as the strike price, on or before a particular date, which is the expiration date. The buyer of a call option anticipates that the price of the underlying asset will increase before the option expires. If the asset’s price rises above the strike price, the call option becomes valuable, allowing the holder to buy the asset at a discount compared to its market price.

Conversely, the seller of a call option, also known as the writer, assumes the obligation to sell the underlying asset at the strike price if the option buyer chooses to exercise their right. Call sellers believe that the underlying asset’s price will remain below the strike price or decline. Their aim is to collect the premium paid by the buyer, hoping the option expires worthless and they are not required to sell the asset.

For example, consider an investor who buys a call option on XYZ stock with a strike price of $50, an expiration date three months away, and a premium of $2 per share. If XYZ stock trades at $45 when the option is purchased, the investor expects it to rise above $50. Should the stock price increase to $55 by the expiration date, the buyer can exercise the option, purchasing shares at $50 each and immediately realizing a gain before accounting for the premium. However, if XYZ stock remains below $50, the option would expire without being exercised, and the buyer would lose the $2 per share premium paid.

What is a Put Option?

A put option is a financial contract that provides the buyer the right, but not the obligation, to sell an underlying asset at a predetermined price, known as the strike price, on or before a specified expiration date. The buyer of a put option expects the price of the underlying asset to decrease below the strike price. If the asset’s price falls, the put option gains value, enabling the holder to sell the asset at a higher price than its current market value.

Conversely, the seller of a put option assumes the obligation to purchase the underlying asset at the strike price if the option buyer decides to exercise their right. Put sellers believe that the underlying asset’s price will remain above the strike price or increase. Their objective is to retain the premium received from the buyer, assuming the option will expire unexercised.

For instance, imagine an investor buys a put option on ABC stock with a strike price of $100, an expiration date two months away, and a premium of $3 per share. If ABC stock is currently trading at $105, the investor anticipates a decline in its price below $100. If the stock price drops to $90 by expiration, the buyer can exercise the option, selling shares at $100 each. This allows them to profit from the price decrease, even after accounting for the premium paid. However, if ABC stock stays above $100, the option would expire without being exercised, and the buyer would incur the loss of the $3 per share premium.

Common Elements of Options Contracts

All options contracts share several common elements that define their terms and conditions. These standardized components ensure clarity and consistency in the options market.

The strike price, also known as the exercise price, is the predetermined price at which the underlying asset can be bought or sold when the option is exercised. This price is fixed at the time the option contract is established. The profitability of an option for its buyer is directly related to how the underlying asset’s market price compares to this strike price.

The expiration date is the final day on which an options contract can be exercised. After this date, the option becomes invalid. Options typically have set expiration cycles, which can range from weekly to several months or even years into the future.

The premium is the price paid by the option buyer to the option seller for the rights granted by the contract. This is a non-refundable fee and represents the cost of purchasing the option. Premiums are quoted per share of the underlying asset, but since one standard equity option contract typically represents 100 shares, the total cost for the buyer is the premium per share multiplied by 100.

The underlying asset is the specific security or financial instrument upon which the option contract is based. This can include stocks, exchange-traded funds (ETFs), commodities, or market indices. The value of the option is directly derived from the price movements of this underlying asset.

The contract size specifies the standard quantity of the underlying asset represented by one options contract. For equity options, the standard contract size is 100 shares of the underlying stock. This standardization simplifies trading and ensures that all participants understand the precise quantity of the asset involved in each contract.

How Options Contracts Function

The functionality of options contracts revolves around the relationship between the underlying asset’s price and the option’s strike price, particularly as the expiration date approaches. This relationship determines an option’s “moneyness,” which indicates its intrinsic value. Options can be in-the-money, out-of-the-money, or at-the-money.

For a call option, it is in-the-money when the underlying asset’s price is above the strike price. It is out-of-the-money when the underlying price is below the strike price. A call option is at-the-money when the underlying price is equal to the strike price. Conversely, for a put option, it is in-the-money when the underlying asset’s price is below the strike price, out-of-the-money when the underlying price is above the strike price, and at-the-money when the prices are equal.

Exercising an option means the option buyer chooses to invoke their right to buy or sell the underlying asset at the strike price. Buyers exercise their options only when the option is in-the-money, as this allows them to realize a profit or avoid a larger loss compared to market prices. The decision to exercise is usually made close to or on the expiration date.

If an option is not exercised by its expiration date, it expires worthless, and the option buyer loses the entire premium paid. This occurs when an option is out-of-the-money at expiration, as there would be no financial benefit to exercising it. The option seller, in this case, retains the premium as profit.

For options that are in-the-money at expiration, the Options Clearing Corporation (OCC) often employs an automatic exercise procedure. This process automatically exercises in-the-money options for the holder, if they are in-the-money by $0.01 or more at the time of expiration. This mechanism helps protect option holders from inadvertently losing potential gains if they do not manually instruct their broker to exercise. However, option holders can provide specific instructions to their broker if they wish to prevent an automatic exercise.