Call vs. Put Options: A Beginner’s Guide
Written by
John Csiszar
Edited by
Melanie Grafil
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In the financial world, options come in one of two flavors: calls and puts. The way that calls and puts function is actually fairly simple. Call options grant buyers the right, not obligation, to purchase an asset at a specified price before expiration. Conversely, put options allow buyers to sell an asset at a certain price before the option’s expiration.
There are plenty of arcane ways that these simple options can become highly leveraged investments, offering investors both high risk and high reward. On the other side of the coin, options can also be used quite conservatively, with little risk to investors other than the small amount of money they invest at the outset.
Here’s an overview of what you’ll need to know before you invest in options.
Introduction to Options Trading
An option is a financial derivative. It has no value in and of itself, but it derives value from the price of another financial asset. Options are primarily used for either speculative gains or as a hedge. When used in combination, some complex strategies can be developed to create custom investment scenarios.
What Are Call Options?
Definition and Purpose
A call option gives an investor the right to buy a stock at a certain level over a certain time. For example, if you buy an October 200 call on Tesla, each contract gives you the right to buy 100 shares of Tesla at $200 per share anytime before it expires in October.
Call options are generally used to generate profits when the price of an asset is expected to rise. As options are leveraged investments, they can gain — or lose — money at a much faster rate than their underlying securities, typically stocks. In other words, if you buy a call option right before a stock rapidly increases in price, your small, leveraged investment could result in a huge gain.
Example of Buying a Call Option
Imagine you paid $15 to buy a Tesla October 200 call when Tesla’s stock price was $180 per share. This would mean you would pay $1,500 in total to buy the option, since each option controls 100 shares of stock. To break even, you’d need Tesla’s stock to reach at least $215, which is the sum of the $200 strike price and the $15 you paid for the option.
If Tesla’s stock price soared to $240 per share by the time the option expired, you’d pocket a gain of $2,500, for a return of 167%. This is about five times as much as what stock investors earned from the stock’s 33.3% movement from $180 to $240.
While this example may make it seem as if buying calls is a much better option than buying stocks, that’s not always the case. Options can carry a great deal more risk than simply owning stock.
In the above example, if Tesla’s stock moved from $180 to $198, stockholders would earn a 10% return. However, as an option holder, your investment would be worth $0, resulting in a 100% loss of your $1,500. If the stock did nothing all year and then doubled in November, stockholders would be celebrating their 100% return, but your option would have expired worthless in October.
What Are Put Options?
Definition and Purpose
Put options allow buyers to sell an asset at a certain price before the option’s expiration. For example, a Tesla October 200 put gives the buyer the right to sell Tesla at $200 per share any time before expiration, regardless of whether the share price is $199 or $9.
Put options are often used as defensive hedges on existing positions. However, they can also be used as a speculative play that a stock’s price will fall.
Example of Buying a Put Option
Imagine you own 100 shares of Tesla that are currently trading at $200 per share. If you’re worried that the share price will fall, either due to general market conditions or company-specific news, you might buy a put option on your shares with a $200 strike price.
That way, if your shares fall to, say $150, you can still sell them for $200 to whoever bought your put option.
Of course, if Tesla rallies instead and rises to $240, your put option will expire worthless. In one sense, though, investors hope that their protective put investments do expire worthless — because it means the stocks that they own have gone up in value.
Key Differences Between Call and Put Options
Call options are generally bullish, meaning they are used in expectation of a gain in the underlying security. Put options are the opposite, bearish bets that a stock, index or other security will fall in value. Both confer the right, but not the obligation, to buy or sell shares at a given price, respectively.
| Call Options | Put Options | |
|---|---|---|
| Rights | Call buyers have the right to purchase the underlying security at a specified price. | Put buyers have the right to sell the underlying security at a specified price. |
| Obligations | Sellers of call options should sell the underlying security at a specified price if exercised. | Sellers of put options should buy the underlying security at a specified price if exercised. |
| Market expectations | Call buyers anticipate a rise in prices; call sellers hope for a flat or down market. | Put buyers anticipate a fall in prices; put sellers hope for a rise in prices. |
| Risk/reward profile | Buying or selling calls can be either conservative or highly risky; buying covered calls offers little risk and little reward, while selling uncovered calls carries theoretically unlimited risk. | Similar to calls, buying and selling puts can be either conservative or aggressive; you risk losing the entire amount you invest if you buy a put. Selling a put could result in even larger losses. |
Selling Call Options
Definition and Purpose
Selling a call gives you the obligation to sell an asset at a set price. When used conservatively, they can generate income and be used to hedge existing stock positions. Speculative strategies, however, could result in losses far greater than the amount of the premium you earn.
Example of Selling a Call Option
One conservative option strategy is to sell a “covered” call, in which you own the underlying stock. If the stock reaches the option’s strike price, you simply hand your shares over to the buying investor, who pays you that price. You’ve also earned the premium you received when you sold the option. If the stock trades sideways or goes down, you keep both your shares and your entire option premium.
But if you instead sell an “uncovered” call, your theoretical loss is much more than 100% — it’s technically infinite. If you sell an uncovered call for, say, $100 per share, you’re entitled to that $100 per share payment from the investor buying your call. If you don’t already own the underlying shares, though, you’ll have to go into the open market and buy them.
Theoretically, the share price of that stock could be infinitely higher — but even if it’s only $200, you’ll be facing a significant loss.
Selling Put Options
Definition and Purpose
If you sell a put, you should buy the underlying asset at a set price. You can sell puts as a way to buy a stock at a given price. For example, if you think the market is falling and you’re willing to buy a stock $10 below its current price, you might sell a put with that strike price. If the market falls and the stock is put to you at that price, the premium you received for selling the option will effectively give you a discount on that price.
Example of Selling a Put Option
Imagine you want to buy Apple at $200 per share, but it currently trades for $240. Meanwhile, Apple puts with a strike price of 200 and a six-month expiration cost of $1.50 in the open market. If you sell one put, you’ll receive $150 in income and take on the obligation to buy the stock at $200 per share. If the stock never falls to that level, you simply pocket the premium. But if it does fall below that level, you’ll pay $200 for the stock or $20,000 for 100 shares. The $150 that you received as an option premium will reduce your effective cost.
Note that significant losses are possible if you sell a put. The investor on the other side can “put” the stock to you at $200 per share, forcing you to buy it even if the market price is now $150.
Risks and Considerations in Options Trading
Options offer the potential for both significant gains and significant losses. With some options, you risk losing your entire investment or even more. However, there are also more conservative uses of options, so it’s essential to understand all of the terms of the contract you’re buying or selling. A well-defined, thoroughly researched strategy can improve your chances of profiting with options. Some options, however, can be exceedingly complex and are best left to experts.
When it comes to buying options, you’re risking losing your entire investment if things don’t move your way.
Imagine, for example, that you’re bullish on Apple and think the price will move up. Currently trading at $240, you buy an Apple June call with a strike price of $260. If the stock never reaches that price, it will be worthless upon expiration unless you sell it before that date while it still has some time value. If the stock trades at $320 when it expires, though, your call option will be worth multiples of what you paid.
The opposite is true if you expect the price of Apple to fall and buy a put. If the share price continually rises and remains above your stock price, your put option will expire worthless. You stand to reap big gains if it falls significantly, though.
Call vs. Put FAQ
Here are the answers to some of the most frequently asked questions you might have about call vs. put options.- What's the difference between call and put options?
- A call option gives the buyer the right to purchase shares of an underlying security at a specific price before a certain date. Put options work in the exact opposite manner, giving the owner the right, but not the obligation, to sell shares of an underlying security at a given price before the expiration date.
- When should an investor consider selling call options?
- Selling calls against an existing position is a popular strategy used to generate income. These so-called "covered calls" generate a premium for the seller in exchange for giving the buyer the right to purchase the underlying shares at a specified price. Covered calls are a good choice in a sideways or falling market.
- On the other hand, selling naked calls is a highly aggressive strategy that exposes the seller to a theoretically infinite loss. This strategy gives buyers the right to purchase shares of the underlying stock at a given price; the seller must buy the shares in the open market at the going price if the call buyer exercises the option, no matter how high the price is.
- What are the risks associated with selling put options?
- If you sell a put, you agree to buy shares at the exercise price of the option, no matter how low they fall in the open market. If you sell a Tesla put with an exercise price of 200 and the stock falls to $100 per share at the expiration date, you still have to buy the stock at $200 per share.
- How can options be used to hedge an investment portfolio?
- If you sell calls against an existing position, you earn an option premium that can help offset any losses if the underlying stock trades down. Buying a put can also offer downside protection. If you own a stock and its price falls in the open market, you can sell your shares at the exercise price of the option, no matter how low they trade.
