In the financial world, options come in one of two flavors: calls and puts. The basic way that calls and puts function is actually fairly simple. A call option is a contract giving you the right to buy a stock at a specified price by a specific date, while a put option gives you the right to sell a stock at a specific price and date.
However, 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.
To fully understand how options work — and how call and put options are different — you’ll have to understand both the terminology that surrounds these financial instruments and the ramifications of using them in various ways. Here’s an overview of what you’ll need to know before you invest in options.
What Is a Call Option?
A call option gives an investor the right to buy a stock at a certain level over a certain time period. 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.
The value of this option is that if the price of Tesla appreciates, your call option could go up in value at a much faster rate, depending on how fast the stock moves. As you’ve invested only a small sum, your leveraged return could be significant.
Potential Gain of Call Options
Imagine you paid $15 to buy this 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 stock investors earned from the stock’s 33.3% movement from $180 to $240.
Potential Loss of Call Options
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 Is a Put Option?
A put option is the polar opposite of a call option. Whereas a call option gives you the right to buy 100 shares of a given stock in a given time period, a put option gives you the right to sell it.
Put options are often used as defensive hedges on stocks that you already own.
Potential Gain of Put Options
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.
Potential Loss of Put Options
Of course, if Tesla rallies instead and rises to $240, your put option will expire worthless. But in one sense, investors hope that their protective put investments do expire worthless — because it means the stocks that they own have gone up in value.
What Are Some Types of Options Strategies?
Buying a speculative call in the hopes that a stock will appreciate — or buying a protective put to hedge against the decline in a stock you own — are two of the most common ways that investors use options.
Covered Calls
One additional 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.
Uncovered Calls
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. But if you don’t already own the underlying shares, 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 Puts
Significant losses are also possible if you sell a put. In this transaction, the investor on the other side of the transaction can “put” the stock to you, forcing you to buy it at the strike price, even if it’s available on the open market for significantly less.
For example, if you sell a Tesla 200 put but the stock falls to $1 per share, you’ll still have to pay $200 for a stock that’s only worth $1.
Which Is Better, a Call Option or a Put Option?
If you expect the price of a stock to rise, buying a call option is the better choice — if you’re right and the stock price goes up, you’ll be able to purchase the stock for less than it’s worth. If you expect the price to decrease, it’s better to buy a put option, so you can sell the stock for more than it’s worth.
Which Carries More Risk, a Call Option or a Put Option?
Technically speaking, selling an uncovered call is the single riskiest options trade. But both calls and puts carry their own risks, depending on how they are used.
The general risk applying to all options is that you have to make a three-pronged determination on a stock, and you have to be correct about all of them to make a profitable trade. Specifically, you must accurately predict:
- The direction that a stock will move
- The time period in which it will move
- The size of the move it will make
This inherently makes options trading more complicated — and potentially risky — than simply trading stocks.
The Bottom Line
Without understanding how stocks move, how the prices of options relate to those movements and how options can be used, it can be risky to work with these financial instruments. However, calls and puts can also be used conservatively to generate income or to protect against stock declines.
Before you dip your toe into the world of options trading, be sure that you’re thoroughly conversant with how they operate and that they fit into your investment objectives and risk tolerance. A long discussion with a financial advisor before you begin is also a smart idea.