Understanding Options: Calls and Puts
Financial derivatives known as options grant the buyer the right, but not the responsibility, to purchase or sell the underlying asset at a predetermined price, referred to as the striking price, on or before a designated date. Options are used to leverage investment positions, speculate, and act as hedging.
Hedging: Options can be used to “hedge” or safeguard an investment from unfavorable price changes. For example, purchasing a put option can help limit your potential losses without having you sell your stock if you own stock in a company and are concerned about short-term downside risk.
Speculation: Options can be used for speculative purposes since they give you the ability to control a larger portion of the underlying asset with a relatively little investment (the premium). Buying options with the hope of profiting from the movement in the option’s price might be done by traders who anticipate that the underlying asset will move in a particular way.
Leverage: Options give leverage since they have the potential for a large return on investment at a modest initial cost. This leverage can compound both wins and losses, so traders must manage their risk carefully.
Call Options
What They Are: Call options grant the buyer the right, but not the responsibility, to acquire the underlying asset at the strike price within the specified time frame.
How They Operate: Purchasing a call option may be appropriate if you think the value of the underlying asset will increase. You can exercise the option to purchase the asset at the cheaper price and possibly make money if the market price rises above the strike price before the option expires.
Example: Let’s say a stock is now trading at $50. For a $2 premium, you purchase a call option with a $55 strike price that expires in one month. You can execute your option to purchase the stock at $55, sell it right away for $60 on the market, and profit (before deducting the premium cost) if the stock climbs to $60.
Put Options
What They Are: When purchasing a put option, the buyer is granted the right, but not the responsibility, to sell the underlying asset at the strike price within the specified time frame.
How They Operate: You may purchase a put option if you think the value of the underlying asset will decrease. You can exercise the option to sell the asset at the higher price and possibly make money if the market price drops below the strike price before the option expires.
Example: Assume a stock is trading at $50 right now. You pay a $2 premium to purchase a put option with a $45, strike price, that expires in one month. You can execute your option to sell at $45, generating a profit (before deducting the premium cost) if the stock drops to $40.
Key Takeaways
Purchases of options (calls or puts) confer rights only; no responsibilities are associated with them. On the other hand, if the buyer exercises the option, selling options has contractual responsibilities that must be met.
Calls and puts have a variety of strategic applications beyond straightforward bullish or bearish wagers. These include hedging, generating income, and leveraging positions.
Risk management: Trading options has a high degree of risk and complexity. If the market moves against what was expected, the premium paid for the options could be lost completely.
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