Options trading can be a great way to profit from stock price movements or protect your portfolio from downside risk. But options trading can also be quite confusing, especially for beginners. So before you buy or sell options, be sure to brush up on all of the different terms and strategies used in this complex field.
In this article, we will dive into the differences between calls vs puts. We will cover what options are, what terminology you need to know, how to trade calls vs puts, and what kinds of risks you should be aware of.
By the time you finish reading, you will have a much clearer understanding of how calls and puts fit into your portfolio and how to use them to your advantage.
What are options?
Most people think of an ‘option’ as a choice between different actions. We don’t necessarily explore all of these available options, but what’s important is that we have the power to choose.
In the financial world, options provide this same freedom. However, there is usually a strong financial incentive to choose one option over another.
An option is a contract that gives the owner the right, but not the obligation, to buy or sell an asset at a specified price within a certain time frame. The asset in question can be anything from a stock or commodity to a currency or even a house.
There are two types of options: calls vs puts.
A call option is a contract that gives the owner the right to buy an asset at a specified price within a certain time frame.
A put option is a contract that gives the owner the right to sell an asset at a specified price within a certain time frame.
Why trade options?
Investors trade options for a few key reasons:
To speculate: When an investor thinks the price of an asset is going to go up, they will buy a call option. If they think the price is going to go down, they will buy a put option. These bets are often placed as a result of technical indicators or broader momentum strategies.
To hedge: When an investor wants to protect their portfolio from downside risk, they might buy put options. This is known as hedging.
To generate income: Investors can also sell options, or “write” options, in order to generate income from the premiums. However, this strategy introduces additional risks and should be avoided by beginners.
Before we dive into calls vs puts, let’s review some helpful options terminology to get you up to speed.
The underlying security is the asset that the option contract gives the owner the right to buy or sell. For example, if we purchase call options on XYZ stock with a strike price of $50, then XYZ is the underlying security.
The price of the underlying security at expiration will determine whether we make a profit or loss on our options contract.
The strike price is the price at which we can buy or sell the underlying security. If we own a call option with a strike price of $50, that means we have the right to buy the underlying stock for $50 upon expiration. And if we own an American-style option we can even exercise that right before expiration.
The strike price is also known as the exercise price. It represents our right to buy or sell the underlying stock in the market at a pre-determined price no matter the current price of the stock.
The expiration date is the date by which we must exercise our option.
If we own a call option with a strike price of $50 that expires in two months, that means we have the right to buy the underlying stock for $50 at any time in the next two months. If, however, we don’t exercise our option by the expiration date, we will no longer have that right and our options contract will expire worthless.
The option premium is the price we pay for the option. It is the amount of money that changes hands when we buy or sell an options contract.
The premium is made up of two parts: the intrinsic value and the extrinsic value.
The intrinsic value is the difference between the strike price and the current price of the underlying security. This is the amount of money we would make (or lose) if we exercised our option right now.
For example, let’s say that XYZ stock is trading at $57 and we own call options with a strike price of $50. In this case, the intrinsic value is $7 per share ($57 – $50).
Extrinsic value (or time value)
The extrinsic value of an options contract is the difference between its premium (market value) and its intrinsic value. Extrinsic value comes from the possibility that the underlying security’s price might move before expiration. This is also known as time value because the longer the time until expiration, the greater the chance that the underlying security’s price might move in your favor.
In the money
If the intrinsic value of an option is positive, then the option is said to be “in the money”. This means that if we exercised our option right now, we would make money.
Out of the money
If the intrinsic value of an option is negative, then the option is said to be “out of the money”. This means that if we exercised our option right now, we would lose money.
At the money
If the intrinsic value of an option is zero, then the option is said to be “at the money”. This means that the current stock price is approximately equal to the strike price of our option.
A spread is an options strategy that involves buying and selling two different options contracts at the same time. There are many different types of spreads, and each one has a different risk/reward profile.
Spreads can be either bullish or bearish in nature. Bullish spreads generally profit if the underlying stock’s price goes up. And bearish spreads profit if the stock price goes down.
“The Greeks” is a term used to describe the various factors that can affect the price of an options contract. These factors are represented by the Greek letters delta, gamma, vega, and theta.
Delta is an options pricing term that measures how much the price of an option contract will change in relation to a 1-point move in the underlying stock’s price. This can help investors understand the sensitivity of their options contract.
Gamma is the rate of change of the delta of an options contract. In other words, it’s a measure of how the delta will change in relation to a 1-point move in the underlying stock’s price. This indicates how volatile the price of the option is.
Vega measures how much an option’s price will change in response to changes in volatility. And in the context of options, volatility is a measure of the amount and speed by which an asset’s price fluctuates.
So, more specifically, vega tells us how much the option price would change if implied volatility increased by 1%. This means that high-vega options are especially susceptible to volatility, and low-vega options are more stable.
Theta is an important concept in options trading because it represents time decay. Time decay is the amount by which the value of an options contract decreases over time. In other words, as we move closer to expiration, theta slowly eats away at the time value of our options contract.
Theta is measured as a percentage and is typically expressed as a negative number.
Types of options: Calls vs puts
Many terms get thrown around in the world of options trading, but none are more important than “call” and “put”. These two types of options contracts allow traders to profit from either upward or downward price movements and set the stage for all other options strategies.
How does a call option work?
When you buy a call option, you are buying the right to purchase a stock at a specific price within a certain time frame. If on the expiration date, the stock’s price is greater than the strike price, you will exercise the option. Call options are a bet that the underlying security’s price will rise
Buying call options
Options are generally quoted on a per-share basis, but sold in lots of 100 shares of stock. So, in practice, a $2 call option on the underlying asset XYZ will actually cost $200.
Suppose you purchase this call option on XYZ, and it is “out of the money” initially. The XYZ stock price is $48 and the strike price is $50, but the expiration date is two months from now.
Exercising call options
Continuing the previous example, imagine that one month after purchasing the call option, the XYZ stock price moves to $51. Your call option is now in the money! Depending on the type of option you have purchased, you may two ways to proceed.
If you purchased an American-style option, you can either exercise your option directly or sell the option contract itself. And if you purchased a European-style option, which cannot be exercised early, you can only sell the contract.
Because the price of the stock moved in your favor, you can likely sell the call option for more than the initial premium you paid. Alternatively, you can wait another month until the expiration date in hopes of realizing some of the “time value” yourself.
If you decide to wait it out, two potential scenarios could unfold:
Scenario A: The XYZ stock price rises further — to $57 per share — so you exercise the option at expiration. Mechanically this means using your call option to purchase 100 shares of the underlying asset XYZ at the agreed-upon strike price of $50. Because the market value of XYZ is currently $57, most investors immediately sell these 100 shares of XYZ to lock in a profit.
In this case, your total earnings on the trade are $500. You made $5,700 selling 100 shares of XYZ, but purchasing those shares cost you $5,000. Plus, you can’t overlook the $200 premium paid for the options contract on day one.
Scenario B: The XYZ stock price falls to $43 per share. In this case, remember that you are not obligated to buy the underlying asset. Your call option is “out of the money”, so it simply expires worthless.
Your option allows you to purchase 100 shares of XYZ at the $50 strike price, but there is no reason to do so. If you still want to own XYZ, you can simply buy it on the open market for $43 per share.
A buyer should not exercise their option here. This trade simply results in a $200 loss, due to the original premium paid for the option.
How does a put option work?
A put option is the opposite of a call option — it gives the buyer the right to sell a stock at a specific price within a certain time frame. Put options are a bet that the underlying security’s price will fall.
Buying put options
Suppose you purchase a put option on XYZ that is “out of the money” for $0.50 per share, or $50 total. The XYZ stock price is $55 and the strike price is $50 with an expiration date that is two months from now.
This means that you have the right to sell XYZ stock for $50 per share. Today, that option is cheap because its only value is derived from the possibility that its price may fall in the coming months.
Exercising put options
Like our previous example, assume the trade initially goes in your favor. The stock’s price suddenly plummets to $40 per share.
At this point, most traders will either hold in expectation of a further decline or sell the option which is now “in the money” and should be much more valuable. However, if you own an American-style option, you could also choose to exercise the option right away.
To exercise your put option, first purchase 100 shares of XYZ on the open market. In this case, that transaction will cost $4,000. Then, use the option to sell those shares of XYZ at the strike price of $50 per share.
Your bottom line on this transaction is $950. You net $1,000 on the final trade and paid $50 to purchase the option.
If, on the other hand, the stock price had not fallen below the strike price, your option would expire worthless. You would not exercise the option, because you could always sell the underlying stock at the market price instead.
Risks of trading calls vs puts
While options trading can be lucrative, it can also be quite risky, especially if you don’t know what you’re doing.
When buying call options and put options, the biggest risk is that you lose all of your money on premiums. While the exact percentage of options that expire worthless is heavily debated — one thing is certain. Far more options go to $0 than stocks or ETFs do. Because they are so volatile, buying options is much riskier than buying stocks.
That being said, selling call options and put options is even more risky. What’s riskier than losing all the money you invested? Losing more than the money you initially invested.
This article has covered the dynamic of buying options, which has capped risk. However, we have not covered the dynamic of selling options, which has the potential for unlimited risk. Until you are an options veteran, stay far away from selling options. And even then, use a covered strategy.
3 common options trading mistakes
So, did we scare you enough? If not, perhaps you are ready to buy your first option. As you look into trading calls vs puts, avoid these common mistakes to minimize your risk:
- Going way out-of-the-money: When you purchase an option that is far out-of-the-money, your odds of making a profit are very low. These options may look cheap and attractive, but they are essentially lottery tickets. Unless something unexpected happens, you are likely to lose your entire premium.
- Not diversifying your portfolio: Trading options is risky enough, but if you put all your eggs in one basket, the risks are amplified. When diversifying your portfolio, be sure to look for uncorrelated assets. For example, don’t go all in on one sector of the S&P 500. Instead, consider a more defensive healthcare stock along with that more aggressive technology bet.
- Trading with emotion: With money on the line, it can be difficult to not let fear or greed get the best of you. But this is exactly how the best traders win. They control their emotions, make a plan, and stick to it.
Every investor should understand the basic dynamics of call-and-put options. Although it can be challenging at first, the risk and reward profiles of each type of option are relatively straightforward.
And just as stock buyers study the fundamentals of a business before investing, options traders look to The Greeks. These tools help measure an option’s sensitivity to time decay, changes in implied volatility, and the underlying asset price.
By understanding these concepts, you can make better-informed decisions when trading options. But if all of this feels too risky, you can always stick to Warren Buffett’s ways of value investing.