Difference Between Put & Call Options

Options can be categorized in a number of ways and there are two basic types: calls and puts. Calls are contracts that give the holder the right to buy the underlying security while puts are contracts that give the holder the right to sell the underlying security. The basic purpose of buying an option is to increase leverage.

Call Options and Example
Call options provide the holder the right (but not the obligation) to purchase an underlying asset at a specified price (the strike price), for a certain period of time. If the stock fails to meet the strike price before the expiration date, the option expires and becomes worthless. Investors buy calls when they think the share price of the underlying security will rise or sell a call if they think it will fall. Selling an option is also referred to as ”writing” an option.

Example:

Company XYZ is currently trading at $50. You think that in three months, the price will rise to $100. A three-month call option contract is available with a strike price of $55 for $1.00 each. With $1000 on hand, you can either buy 20 shares of XYZ at $50, or you can buy 10 contracts for $1.00 each.

In three months, if the stock price is at $100, your profit is:
Buy 20 Shares
$100 – $55 – $1(premium) = $44 multiplied by 20 shares = about $880 (not including commission).

OR
Buy 10 Call Option Contracts
$100 – $55 – $1(premium) = $44 multiplied by 1000 options (ten contracts multiplied by 100 options) = about $44,000 (not including commission). You can exercise your option, buy the stock for $55 and sell it in the market for $100.

What happens if in three months from now, the stock does not rise to $100, but instead falls to $30?
Since you bought the call option, you don’t have the obligation to buy company XYZ for $55. Therefore, you let the option expire; causing you to lose $1000 (the entire cost of the option).

Put Options and Example
Put options give the holder the right to sell an underlying asset at a specified price (the strike price). The seller (or writer) of the put option is obligated to buy the stock at the strike price. Put options can be exercised at any time before the option expires. Investors buy puts if they think the share price of the underlying stock will fall, or sell one if they think it will rise. Put buyers – those who hold a “long” – put are either speculative buyers looking for leverage or “insurance” buyers who want to protect their long positions in a stock for the period of time covered by the option. Put sellers hold a “short” expecting the market to move upward (or at least stay stable) A worst-case scenario for a put seller is a downward market turn. The maximum profit is limited to the put premium received and is achieved when the price of the underlying asset is at or above the option’s strike price at expiration. The maximum loss is unlimited for an uncovered put writer.

Example:

Company XYZ is currently trading at $50. You think that in three months, the price will fall to $10. A three-month put option contract is also available with a strike price of $45 for $1.00 each. With $1000 on hand, you can buy 10 contracts for $1.00 each. In three months, if the stock price is at $10, your profit is:

Buy 10 Put Option Contracts
$50 – $10 – $1(premium) = $39 multiplied by 1000 options (ten contracts multiplied by 100 options) = about $39,000 (not including commission). You can exercise your option and sell company XYZ at $45 while it’s selling in the market for $10.

What happens if in three months from now, the stock does not fall to $10, but rises to $100 instead?
Since you bought the put option, you don’t have the obligation to sell company XYZ for $45. Therefore, you let the option expire; causing you to lose $1000 (the entire cost of your options).

As you can see, the basic purpose of options is to increase your leverage in making an investment. There is a fundamental difference between calls and puts which you will now grasp, but the elevated risk applies to all options in general.