Call and Put Options: Meaning, Types & Example

Summary of the two basic types of stock options: call options and put options.
Call and Put Options: Meaning, Types & Example
3 mins
14 July 2023

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 Reliance Industries 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 RIL’s price to increase beyond Rs. 1500.

If RIL’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 RIL’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.

Put option trading with an example

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.

Call and put options are important derivative instruments through which traders and investors try to make additional profits or recover losses. A call and put option is the opposite of each other and thus is used in different scenarios and with different purposes.

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