Call and Put Options

​​Key takeaways

• A call option allows you to buy a stock in the future, while a put option grants the right to sell the security at a specified price.
• Put options involves risks and may not be suitable for everyone, as it may lead to substantial losses.

Stock market investors have different avenues for investment. These include directly investing in stocks, mutual funds, ETFs (exchange-traded funds), or derivatives such as futures and options. There are primarily two options in the stock market- call option and put option. These are contracts that derive their value from their underlying stock.

What are call and put options?

Options are derivatives, financial instruments that derive their value from their underlying asset. Unlike futures, options give its buyer the right but no obligations to buy/sell an underlying asset, which can be a stock, index, currency, or commodity.

A call option gives the buyer the right, but not any obligation, to buy a particular stock at a pre-defined price on the expiration date. A put option gives the right to an investor, but not an obligation, to sell a particular stock at a predetermined rate on the expiration date.

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 it 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 toas 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:

1. 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.
2. 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.
3. 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.
4. 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.

Basic terms relating to call and put options

Understanding the basic terms associated with call and put options is crucial for investors to navigate the options market effectively.

1. 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.
2. 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.
3. 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.
4. 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.
5. Settlement: Settlement refers to the process by which options contracts are resolved.

Difference between call option & put option

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.