When you talk about stock options, it is impossible not to talk about call and put options. Call and put options are incredibly important in investing because they dictate whether you are buying or selling an option. Knowing how a stock is going to do, or having a general idea, is important when investing with call and put options.
A call option is when a buyer and seller enter into a contract with each other on an option. By purchasing a call option, you can buy shares of a stock at a specific time in the future. It is important to note that the buyer has the right, but is not obligated to, buy the underlying asset in the future. The price that is decided on is the strike price. If the buyer exercises the option, the seller is obligated to sell the underlying asset at a certain price. The buyer pays off a premium to the seller.
With a call, the buyer wants the price of the asset to rise before the expiry date. The seller is expecting that it will not. If the price does rise, then the buyer will exercise the option before the expiry so that they can buy the asset for less than it is worth at the time. If the price goes down, the buyer will generally let the option expire. If this happens, then the buyer will only be out the premium. While the risk is limited by the price of the premium, the profit potential is extremely large.
A put option is a contract between a seller and a buyer, in which the buyer has the right to sell an underlying asset at a strike price without any compulsion. If the option is exercised, the seller is obligated to buy the option at the strike price. For this right, the buyer pays the seller the right through a premium. With a put, the buyer believes that the asset will fall in price before the expiry date.
In contrast, the seller believes that the price of the underlying asset will rise rather than fall. The seller sells the put to collect the premium. If the option is not exercised, the seller retains the underlying asset and they can then resell the put and hope to collect more premiums while not losing their asset.
If the underlying asset’s price is below the strike price when expiry approaches, the buyer will typically exercise the option, making the seller sell it to them. The buyer profits from the difference between the stock’s market price and the strike price. If the price is above the option’s strike price near the expiry day, the option expires worthless and the buyer only loses the premium that they paid. For a seller, the potential loss they can incur can be very large. If the underlying asset value falls to zero, then he will lose the amount equal to the strike price minus the premium.
It can be a tricky business to be selling and buying options through call and put options. While there are many types of call and put options, including long, short and naked, having a basic understanding of the differences between call and put options is important. A great deal of understanding must be had of how a stock market, and individuals stocks in it, are going to move in order to make money with call and put options. Investing in call and put options is not for the faint of heart.
Refer your friends to OptionsHouse and get your choice of $150 or 30 commission-free trades.