Options contracts are categorised into two main types based on their exercise conditions:
- US Option Contracts
These options can be exercised at any point before their expiration date, offering greater flexibility for the holder. This makes US options particularly popular among traders, as they allow for timely responses to market fluctuations.
- European Option Contracts
Unlike US options, European options can only be exercised on their expiration date. While less flexible, these contracts can be simpler to manage as they reduce the potential for mid-term decisions.
In most cases, examples of call and put options traded in markets are associated with US-style contracts, as these can be conveniently squared off at any time prior to expiry. This flexibility is one of the key reasons for their prevalence in trading activities.
Call option in the share market
Call options trading is a contract which provides rights to purchase a particular stock at a predetermined price and expiry date. A buyer of a call option in the share market isn’t obligated to honour the contract. However, sellers must fulfil the contract’s terms if it’s exercised.
How does call option work?
Call options are standardised contracts available on stock exchanges like BSE (Bombay Stock Exchange) or NSE (National Stock Exchange). One must open a Demat and trading account to trade with options. An options seller or writer enters a transactional contract with the buyer of an option. An options buyer can choose to buy shares on a specific date, while its seller is only obligated if the buyer exercises his/her contract.
Options are traded in terms of lots. The number of shares in a stock call options lot is generally 100. To get a contract, a call buyer must pay a nominal price called option premium. This premium amount goes to the options seller or writer.
When the price of a stock goes beyond a contract’s strike price, the transaction may take place on a specific expiration date. Thus, a call option has an intrinsic or trade-in value. In such a scenario, exercising a call option can let its buyer purchase the stock at a much lower price.
Example of call option trading
Let us suppose that the price of ABC Limited stocks stands at Rs. 1000 per share. Investor B has 100 such shares and wants to generate income beyond the dividend.
According to investor B’s calculation, the stocks are highly unlikely to go beyond Rs. 1500. So, he sells a call option trading at Rs. 1500 where the premium payable for each contract is Rs. 500. He sells one call option to investor A and receives a premium of Rs. 500. Here, investor A buys this call option expecting ABC’s price to increase beyond Rs. 1500.
If ABC’s prevailing price exceeds its strike price on the expiration day, investor B has to sell the share at the agreed-upon strike price to investor A. However, if ABC’s share price does not exceed its strike price, investor B gets to keep his shares and earn the premium money additionally.
An investor can enter a call options contract as a seller without possessing the underlying asset. It is referred to as a naked call option.
Put option in the share market
A put option gives its buyer the right to sell its underlying stock at a predetermined strike price on the expiration date. However, a put buyer isn’t obligated to honour his/her contract. In contrast, put sellers must sell the underlying stock when the put buyer exercises his/her option.
Investors buy put options when predicting a decrease in the price of an underlying asset. On the other hand, sellers are driven by the prediction that an asset’s market price will either increase or remain stable.
How does put options work?
The function of a put option hinges on market movements and the investor's strategy, primarily serving as a tool for speculation or as a hedge against declines in the underlying asset’s price.
How it works:
- Buying a put option: When you purchase a put option, you are essentially expecting that the price of the underlying stock will fall below the strike price before the option expires. If this happens, the put option increases in value, and you can either sell the option itself for a profit or exercise the option to sell the underlying shares at the higher strike price (regardless of the lower market price). This can provide significant gains relative to the premium paid if the stock falls substantially.
- Selling a put option: Conversely, when you sell a put option, you are predicting that the price of the underlying stock will not fall below the strike price. If you are correct, the option will expire worthless, and you keep the premium received as profit. However, if the stock price falls below the strike price, you might be obligated to buy the stock at a higher price than the market value, leading to potential losses.
- Hedging: Investors holding shares in a stock might buy put options to hedge or protect their investment against a potential drop in share price. In this case, if the stock price falls, the losses in the stock are offset by gains in the value of the put options.
- Premium and stock price correlation: The premium of a put option tends to increase as the underlying stock price decreases and decreases as the stock price rises. This inverse relationship is due to the increased likelihood of the option being exercised (and thus becoming more valuable) as the stock price moves below the strike price.
Example of put option trading
How a put option works can be better illustrated with the help of an example. Let us say investor X decides to buy a put option with the expectation of a price decline. The current price of this stock is Rs. 800, and he is predicting its price to go down up to Rs. 600. He enters a put option contract with investor Y with a strike price of Rs. 600.
On the date of expiry, if the underlying stock’s price falls below Rs. 600, this put buyer will exercise his right. Then, the put buyer gets to sell the underlying stock at the predetermined strike price. The profit that he earns will be the difference between the stock’s strike price and its current price.
However, if the price stays at Rs. 600 or above, the put buyer will refrain from exercising his right, and the put seller gains the premium from the contract.
Additional read: What is Trading
Basic terms relating to put and call options
Understanding the basic terms associated with put and call options is crucial for investors to navigate the options market effectively.
- Spot price: The spot price refers to the current market price of the underlying asset. For options, this is the price of the asset within the stock market at the time of consideration.
- Strike price: The strike price, also known as the exercise price, is the price at which the buyer and seller agree to buy or sell the underlying asset upon exercising the option. It's the fixed price specified in the option contract.
- Option premium: The option premium is the amount paid by the buyer to the seller for the option contract. It is essentially the price of the option. The premium is paid upfront by the option buyer and is non-refundable, regardless of whether the option is exercised or expires worthless.
- Option expiry: Options contracts have a finite lifespan, known as the expiration date or expiry. The expiry date is the date by which the option contract must be exercised or allowed to expire. In many markets, including India, options contracts typically expire on the last Thursday of the month.
- Settlement: Settlement refers to the process by which options contracts are resolved.
Difference between call option & put option
Let us explore some key differences between call and put option:
Parameters
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Call Option
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Put Option
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Meaning
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Provides buying rights without obligation to buy
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Provides selling rights without obligation to sell
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Expectations of investors
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Expects stock prices to increase
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Expects stock prices to decrease
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Gains
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Unlimited gains
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Limited gains (stock prices won’t become zero)
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Loss
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Loss typically limited to premium paid
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Maximum loss is strike price minus premium amount
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Reaction towards dividend
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Loses value as dividend date nears
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Increases in value as dividend date nears
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How to calculate call option payoffs?
Calculating call option payoffs during call option trading requires knowing three variables: strike price, expiry date, and premium. Once you know these three variables, you can calculate the call option payoff, which is divided into two categories: Conclusion
- Payoff for call option buyers: Let us assume that you have bought a call option with an expiry date of 30th August and a strike price of Rs. 250. You have paid a premium of Rs. 100. Here, you will start earning profits only after the stock price rises above Rs. 350, as you have also paid a premium of Rs. 100. Here is how you can calculate your payoff and profit: Payoff = Spot price - strike price
Profit = Payoff - premium amount
- Payoff for call option sellers: Using the above example, you will start earning as a call option seller if the stock price decreases below the call option's strike price. However, your losses can be unlimited if you have to purchase the underlying stock at the spot price. Here is how you can calculate the payoff as a seller:
Payoff = Spot price - strike price
Profit = Payoff + premium amount
How to calculate put option payoffs?
Put option payoffs depend on two factors: the premium paid for the put option at the beginning and the things you might receive when exercising it. Here, you can earn profits when the underlying price falls lower than the strike price.
- Payoff for put option buyers: As a put option buyer, the profit and loss entirely depend on the underlying asset's spot price at the time of expiry. You can make a significant profit if the underlying asset’s spot price is below the strike price at expiry. However, if it is above the strike price, most buyers let the option expire, limiting their loss to the paid premium amount.
- Payoff for put option sellers: The sellers charge a premium when selling a put option. The profit made by the buyers of the put option is the seller's loss. This is because the buyer can exercise the option if the spot price is lower than the strike price. And if it is the opposite, the seller will only get the premium amount as profit as the buyer will let the option expire.
Risk vs reward – Call Option and put option
Here is a detailed table for call option and put option risks vs. rewards:
Parameters
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Call option buyers
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Call option sellers
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Put option buyers
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Put option sellers
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Maximum profit
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Unlimited
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Received premium amount
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Strike price - premium paid
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Received premium amount
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Maximum loss
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Premium paid
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Unlimited
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Premium paid
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Strike price - premium paid
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Zero profit - zero loss
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Strike price + premium paid
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Strike price + premium paid
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Strike price - premium paid
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Strike price - premium paid
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Suitable action
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Exercise
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Expire
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Exercise
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Expire
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What happens to call options on expiry? – Buying call option
While buying a call option in the share market, numerous things can happen, resulting in profits or losses for the buyers. If you are a call option buyer, here are the things that can happen to your call options on expiry:
- Out-of-money call options: This is when the market price is lower than the strike price of a call option. In this case, you lose money and incur losses.
- In-the-money call options: This is when the market price is higher than the strike price of a call option. In this case, you earn and make profits.
- At-the-money call options: This is when the market price is equal to the strike price of a call option. In this case, you break even; you don’t make profits or incur losses.
What happens to call options on expiry? – Selling call option
Selling a call option during call option trading is a complex task that needs understanding of the potential outcomes based on different scenarios. Here are the things that can happen to your call options at expiry if you are the seller:
- Out-of-money call options: This is when the market price is lower than the strike price of a call option. In this case, you earn and make profits.
- In-the-money call options: This is when the market price is higher than the strike price of a call option. In this case, you lose money and incur losses.
- At-the-money call options: This is when the market price is equal to the strike price of a call option. In this case, you make a profit equalling the premium amount.
What happens to put options on expiry? – Buying put option
Understanding the different outcomes that can happen while buying put options under call option and put option trading is crucial, as your profit and loss depend on them. Here is what can happen to your put options on expiry as a buyer:
- Out-of-money put options: This is when the market price is higher than the strike price of a put option. In this case, you incur losses.
- In-the-money put options: This is when the market price is lower than the strike price of a put option. In this case, you make profits.
- At-the-money put options: This is when the market price is equal to the strike price of a put option. In this case, you make a loss equalling the premium amount.
What happens to put options on expiry? – Selling put option
In call option put option, if you are the seller of a put option, here are the things that can happen at expiry:
- Out-of-money put options: This is when the market price is higher than the strike price of a put option. In this case, you make profits.
- In-the-money put options: This is when the market price is lower than the strike price of a put option. In this case, you incur losses.
- At-the-money put options: This is when the market price is equal to the strike price of a put option. In this case, you make a profit equalling the premium amount.
Conclusion
Call and put options are important derivative instruments through which traders and investors try to make additional profits or recover losses. A call & put option is the opposite of each other and thus is used in different scenarios and with different purposes.
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