Call Option vs Put Option: What’s the Difference?
We live in a world of high volatility. When you are faced with uncertainty, call options and put options can be an excellent way to hedge your bets on the market. You should know that it is important to be careful when trading call or put options. Both of these strategies can leave you with significant losses if not used correctly.
Call options give the holder the right to purchase a stock at a predetermined price within a certain time frame. If you are bullish on a stock, call options can be used as an alternative to purchasing that company’s shares. In addition, call options can be used if your investment horizon is short and you want to limit how much of the underlying stock you purchase at one time. Call options can be in, at, out of the money, which means:
- In the money – call options have a strike price that is below the current market.
- At the money – call options are when the strike price of an option equals the underlying share’s market value.
- Out of the money – call options have a strike price above or higher than its stock’s market value at the expiration time.
Put options give you the right to sell a stock at a predetermined price within a certain time frame. If you are bearish on an underlying stock, put options can be used as an alternative strategy to short-selling that company’s shares. Call options can also be used if your investment horizon is longer and you want to limit how much of the underlying stock you sell at one time. Put options can also be in, at, out of the money, implying:
- In the money – call options have a strike price that is above the current market.
- At the money – call options are when the strike price of an option equals its underlying share’s market value.
- Out of the money – call options have a strike price below or lower than their stock’s market value at the expiration time.
How Do Call and Put Options Work?
For call options, you are betting that the market price of a stock will increase in value. If it does, then your call option becomes more valuable. The strike price represents the predetermined price for a call buyer to buy the underlying asset with call options. For instance, with call options, the buyer of a call option with a strike price of $50 can use that call to buy 100 shares in Apple at $50 before expiration. On the other hand, put options give you the right to sell an asset for a predetermined price before the expiration. If a put option is directed in the money, the buyer of that call can sell 100 shares at $50. If you are bullish on a stock, call options can be used as an alternative to purchasing that company’s shares. In addition, call options can also be used if your investment horizon is longer and you want to limit how much of the underlying stock you sell at one time.
When Should You Use Call and Put Options?
Put and call options are great for investors who want to limit risk exposure or use the leverage of derivatives without having direct market exposure. If you believe the market will increase, call options to allow for cost-effective exposure. Put options can be used to reduce risk on a short position or when hedging your portfolio against an overall decline in shares. Call options can also be utilized as a speculative call on the direction of an underlying asset, while put options can also be used to hedge against stock price declines.
The Benefits of Call and Put Options
Limited Risk Exposure.
By using the call or put option, you can place a ceiling on your potential loss if the stock price falls below the strike price while also having the opportunity to make some money if call options move in your favor.
Call and put option contracts are relatively flexible because you can buy or sell call/puts even when there is no movement in price, as long as time value decreases over time with expiration nearing.
Risks of Using Put and Call Options
Risk of Unlimited Losses.
If not executed properly, buying call option contracts without covering them could result in unlimited losses while selling puts at inflated prices is considered risky.
Expensive Fees Involved.
There are commissions involved with trading these derivatives (both on an initial purchase and sale) along with fees charged by brokers for each transaction made; therefore, call and put options are relatively costly.
Inability to Short Shares.
Call and put options cannot be used as a substitute for short selling.
Call and put options are great investment vehicles that allow you to take advantage of your market view without incurring the risk of directly trading shares. If the call or put option is exercised before expiration, it can lead to unlimited losses if not properly executed; therefore, placing stops on these derivatives is essential in protecting capital from further erosion. In addition, call and put options can also incur expensive fees involved with every transaction made by investors, along with commissions charged each time they buy or sell call/put contracts through their brokerages. Consequently, call and puts should only be considered after meticulous consideration because there is no way to determine the actual price of call and put options without taking into account market variables such as strike prices, expiration dates, or underlying assets.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.