Call vs. Put Options Explained

Key Takeaways:

• With a call option, the buyer has the right – but not the obligation – to purchase the underlying asset at a price certain before it expires.

• A put option gives the buyer the right to sell an underlying asset at a specified strike price before the option expires. As with call options, the buyer is not obliged to act.

• Options trading requires correct prediction of the direction and amount the stock will move, as well as the time period such movement will occur.

The terms “call option” and “put option” are key to options trading and stock market strategy. Thus, it is important to fully understand the chief similarities and differences between the two options. With that said, the following covers call vs. put options.

What is an Options Contract?

A pact between two parties agreeing to conduct a prospective transaction involving an asset at a preset amount and date is referred to as an options contract. The value of such contract is based on the underlying asset, usually a publicly traded financial instrument such as a stock or exchange-traded fund. The two primary types of options are “call” and “put.”

Generally, such an agreement involves a:

• Premium. The cost to purchase the right to make the trade.
• Expiration date. The last day on which the right to exercise the options contract is valid.
• Strike price. The amount the investor pays if they use their option to buy or sell.
• Amount. The number of options contracts that are bought or sold.

What is a Call Option?

With a call option, the buyer has the right – but not the obligation – to purchase the underlying asset at a price certain before it expires.

What is a Put Option?

A put option gives the buyer the right to sell an underlying asset at a specified strike price before the option expires. As with call options, the buyer is not obliged to act.

Types of Call Options

The various types of call options include:

• Long. This gives the investor the right to buy shares of a certain stock at a later date for a preset price.
• Short. This position is taken when a trader thinks the price of the asset underlying the option will fall.
• Covered. This is when an investor writes a call option for an asset they already own when they believe the price will remain unchanged or decrease by the expiration date.
• Naked. The investor here is obliged to buy shares at the “spot price” – the current marketplace price – when the option is exercised. They then sell the shares to the holder for the strike price.

What are Common Strategies for Puts?

Common investment approaches for puts include:

• Protective put. This strategy involves purchasing stock and buying put options on a share-for-share basis. Think of it as an insurance for your stock holdings. If the stock price falls below the put’s strike price, the put option increases in value, offsetting losses on the stock. This limits potential losses while allowing for unlimited upside potential. This strategy is often used by investors who are bullish on a stock long-term but want protection against short-term declines.
• Put spread. This strategy involves purchasing a put option at one strike price and selling another put option at a lower strike price, both with the same expiration date. This reduces the cost of buying the put option alone, as the premium received from selling the lower strike put partially offsets the cost of the higher strike put. The tradeoff is that it also caps the potential profit. This strategy is useful when an investor expects a moderate decline in the underlying asset’s price.
• Covered put: In this strategy, an investor writes (sells) put options against a short position in the underlying stock. The investor first borrows shares and sells them (short selling), then writes put options on the same stock. If the stock price rises, losses on the short position are partially offset by the premium received from writing the put. If the stock price falls, the investor profits from the short position, but may have to buy shares at the put’s strike price. This strategy is used when an investor is bearish on a stock but wants to generate additional income.
• Naked put: Within this strategy, the investor writes put options without holding a short position in the underlying security. The investor collects the premium from selling the put and profits if the stock price stays above the strike price at expiration. But, if the stock price falls below the strike price, the investor may be obligated to buy shares at the strike price, potentially resulting in significant losses. This strategy is used by investors who are neutral to bullish on a stock and want to generate income, but it carries substantial risk.

Similarities between Call and Put Options

Both the call vs put option give investors the right to buy and sell stock shares at a set price during a certain period. With both, investors have rights sans obligations.

Differences Call vs Put Options

• While call options give the holder the right to buy shares, put options provide the right to sell shares.
• With call options, the seller will have unlimited risk while the option seller in put options has limited risk.
• The buyer in call options has limited risk.
• An options buyer in put options has limited risk.

Factors Affecting Options Pricing

There are several factors that can influence options pricing:

• Higher market volatility typically increases option prices. This is because greater price swings in the underlying asset create more opportunities for profit.
• As an option nears its expiration date, its time value decreases. This is known as time decay or theta. Time decay accelerates as expiration approaches, affecting the option’s overall value.
• Changes in the underlying asset’s price as this directly impacts an option’s intrinsic value.
• Higher interest rates tend to increase call option prices and decrease put option prices.

Example of Buying a Call Option

Say an investor thinks the price of ABC stock will increase in a year, but they are uncertain whether the price, currently at $30 per share, will first decrease. Because of their uncertainty, they buy a call option that expires in a year and has a per-share strike price of $32. Because the premium is $0.50, an options contract will cost $50 ($0.50 multiplied by 100 shares).

Purchase of the call option contract gives the investor the right to buy ABC at $32 per share before it expires. The investor will only do so if they can profit – if the share reaches the breakeven point of $32.51 per share. If the stock does not trade at that price prior to expiration, they will lose their $50 premium.

Now, if ABC trades at $35 per share before expiration, and the investor exercises their call option to buy at $32 per share, the profit would be $35 minus $32 multiplied by 100 shares minus $50. That comes to $250.

Example of Buying a Put Option

Say an investor thinks the price of XYZ stock, currently at $20 per share, will fall in a year. Thus, the investor decides to buy a put option at a strike price of $18 per share that expires in a year. Because the premium is $0.45, the investor must pay $45 for one option contract.

While the investor has the right to sell XYZ at $18 per share before it expires, they will only do so if the price reaches $17.54 per share. The breakeven price is $17.55. To make a profit, the price of XYZ must be $17.54 or under. If such pricing does not happen before the stock expires, the $45 premium will be lost.

However, if the stock trades at $15 per before it expires, and the put option to sell XYZ at $18 per share is exercised, the profit would be $18 minus $15 times 100 shares, minus $45. That comes to $255.

What are Risks Associated with Each Option?

Here is a look at risks for call vs. put options.

Call Option Risks

• If the stock’s value is unchanged or falls below the stock price, there is no value for the holder.
• One’s premium may be lost if their option isn’t exercised.
• Stock shares may be lost if a covered call option sold is exercised under the spot price.
• Could lose money if a naked call option sold is exercised under the spot price.

Put Option Risks

• Expires worthless if the stock does not reach the breakeven point. If it does not, the investor loses their premium.
• The potential profit of a put option is limited by how low the price of the underlying asset can go.
• Premiums are more than for call options.
• Large losses are possible.

Rewards Associated with Each Option

Call Option Rewards

• Buying a call option on a stock that increases in value before it expires can yield substantial profits.
• The premium for a call is typically less than for a put option.
• If a call option is sold, the investor can collect a premium for each share.

Put Option Rewards

• One knows from the start the most they can lose.
• Can generate profits if market prices go under the strike price.
• Can generate income by charging a premium.

When Should You Buy/Sell Puts and Call Options?

Basically, options trading requires correct prediction of the direction and amount the stock will move, as well as the time period such movement will occur.

Using Options for Hedging

Options are also valuable for hedging. Hedging with options can protect investments against potential market downturns. For example:

1. Buying put options on stocks you own can limit potential losses if the stock price falls.
2. Using call options can hedge short positions, capping potential losses if the stock price rises.
3. Investors can use options to hedge against currency fluctuations in foreign investments.

Hedging can reduce risk in a portfolio, though it may also limit potential gains.

How to Invest Outside the Stock Market

Given the risks involved with options trading, and a stock market that is intrinsically volatile, it may be wise to explore investments other than stocks and bonds. Investing in “alternatives” such as real estate, art, venture capital, and collectibles can help diversify one’s portfolio while protecting against inflation and generating steady returns.

Alternative Investments and Portfolio Diversification

Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.

Alternative investments like real estate, private equity, and collectibles offer diversification potential beyond public markets, traditionally reserved for wealthy individuals and institutions due to high minimums ($500,000+) and increased risk profiles, though these barriers are evolving to allow broader investor access.

To democratize these opportunities, Willow Wealth has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments.

Learn more about the ways Willow Wealth can help diversify and grow portfolios.

Summary

Strategy-wise, it is important for investors to have a full understanding of call vs. put options, including their risks and benefits. It is also important, particularly in this uncertain economy, to understand investment options with limited correlation to the stock market.