What is the difference between call and put options?
If you are new to Futures and Options (F&O) trading, it’s quite possible that you have briefly heard about calls and puts but don’t know much beyond that. This article aims to help you not just understand the difference between call and put options but develop a basic understanding of how to use calls and puts effectively in trading.
First of all, what are options?
Options are derivative contracts that offer its buyer a choice to buy or sell an underlying asset, say a stock or a commodity or a currency, at a specified date and a pre-determined price, without creating any obligation thereof.
Like in any other trade, an option trade involves two parties—a buyer and a seller (writer).
What is a call option?
The ‘Call’ option gives the option buyer the right to buy an underlying asset at a stated strike price on a specified date. More often than not, a call option buyer holds a bullish view on the underlying asset.
As far as the call buyer is concerned:
- A call is said to be In The Money (ITM) when the spot price> strike price
- A call is said to be At The Money (ATM) when the strike price=spot price
- A call is said to be Out of The Money (OTM) when the strike price > spot price
Conversely, the writer of a call will have an opposite market view and an inverse pay-off.
Trade-off of a call option contract
Rakesh pays Rs 20 premium to buy a call with a strike price of Rs 2,000. On the other hand, Ramesh collects the premium of Rs 20 being a call writer. Now as long as the stock price remains below 2020 Rakesh will continue to make a loss. His maximum loss is restricted to the premium of Rs 20 (multiplied by the lot size, say, 250)—works out to be Rs 5,000.
Profit and loss potential of a call
Ramesh will continue to make a profit as long as the stock price stays below Rs 2020. Beyond this price Rakesh will, although theoretically, have a scope for unlimited profit whereas losses of Ramesh could be unlimited beyond the same price point.
What is a put option?
Put option gives the option buyer the right to sell an underlying asset at a stated strike price on a specified date.
As far as the put option buyer is concerned:
- A put is said to be ITM when the strike price > spot price
- A put is said to be ATM when the strike price=spot price
- A put is said to be OTM when the spot price > strike price
Trade-off of a call option contract
Let’s assume Rakesh had a bullish view on a stock and wrote a put with a strike price of Rs 2,000 for a premium (fee) of Rs 20. Conversely, Ramesh, a bear, opted to buy a put with the same strike price by paying a premium of Rs 20.
Profit and loss potential of a put
If the stock price falls below Rs 1,980 the put option writer Rakesh will, theoretically, make unlimited losses while the profit potential for Ramesh will be unlimited.
Please note: The primary role of call and put options is hedging but in practice, options are also used for speculative purposes. This is where you have to be a bit careful with calls and puts, especially if you are new to F&O trading.
Call option Vs Put Option (from a buyer’s perspective)
|Call Option||Put Option|
|Market outlook/ view||Buyer of a call option will have a bullish view on the market||Buyer of a put will have a bearish view|
|Trade-off||Loss is limited to the extent of premium paid to buy a call. The trade becomes profitable as soon as the market price of an asset exceeds the premium adjusted strike price.||Loss is limited to the extent of premium paid to buy a put. The trade becomes profitable as soon as the market price of an asset falls below the premium adjusted strike price.|
Difference between call and put options (from a writer’s perspective)
|Call Option||Put Option|
|Market outlook/ view||Writer of a call option will have a bearish view on the market||A put writer will have a bullish view|
|Trade-off||Profit is limited to an extent of premium collected. In theory, losses are unlimited once the market price exceeds the premium adjusted strike price.||Profit is limited to the extent of put writing premium. The trade incurs losses as soon as the market price of an asset falls below the premium adjusted strike price.|
Usually, a call option buyer and a put writer may agree on the market direction; but their view on market volatility could be different. Likewise, a put option buyer and a call writer may have a similar view on the market direction but their take on market volatility could be different.
In other words, having a bullish or bearish market view isn’t enough to be a successful options trader.
Primary factors affecting the risk-return trade-off of a plain vanilla option contract are:
- Current market price of an asset
- Time to expiry (of a contract)
- And anticipated volatility
An option buyer usually bets on high uncertainty and high volatility while an option writer bets largely on time decay and low volatility.
Now that you thoroughly understand what call and put options are, check out how you can use them to hedge your trades.
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