Categories: Financial Glossary

What is: Call and Put Options

All stock trading depends on 2 terms. Either you could be bullish or bearish. Depending on whether you are bullish or bearish on the underlying stock, you could purchase either a call option or a put option.

Buying a call Option

When you buy a call option, you hold the right to buy a specified quantity of the underlying stock at the strike price on or before the expiration date.

If you are bullish on a stock you could purchase a call option at a predetermine (Called it as the strike price) that is lower than the appreciation you expect then, if all goes well and the stock price does rise beyond the strike price + the premium you have paid, on or before the expiration of the contract, you can exercise your option to buy the stock at the strike price and simultaneously sell it in the spot market. i.e. the cash market to book your profit.

If, on the other hand the price of the stock in the cash market does not rise beyond the strike price + premium, you can let the contract lapse, i.e. you do not buy the underline stock at the strike price. Your loss in such a case would be premium you have paid. However in India equity options and futures are currently cash settled and are not settled by delivery.

Example

Current spot price per share = Rs 100
Premium payable per share = Rs 10
ABC company has a lot size = 50 shares

If the spot prices rises to Rs 120 per share before the contract expires you could exercise your option to buy the shares at Rs 100 and then sell them in the market for Rs 120. Your profit in this transaction would be Rs 500 (Sale price of Rs 120 x 50 – purchase of 100 x 50) – premium of 10 x 50)

If, on the other hand if the price does not go beyond Rs 100 until the expiry date, you could just let the contract lapse. In this case, your loss would be equal the premium that you have paid. i.e. Rs 500

Buying a put Option

When you buy a put option, you hold the right to sell a specified quantity of the underlying stock at the strike price on or before the expiration date.

If you are bearish on a stock you could purchase a put option at a pre-determine (strike price) that is higher than the fall you expect in the price of the stock,

If all goes well and the stock price does fall beyond the strike price + the premium you have paid, on or before the expiration of the contract, you can exercise your option to sell the stock at the strike price and simultaneously buy it in the spot market. i.e. the cash market to book your profit.

If, on the other hand the price of the stock in the cash market does not fall to the strike price + premium you can let the contract lapse, i.e. you do not sell the underlying stock at the strike price. Your loss in such a case would be premium you have paid.

Going with the above example if the spot prices depreciate to Rs 80 per share before the contract expires you could exercise your option to sell the shares at Rs 100 and then buy them in the market for Rs 80. Your profit in this transaction would be Rs 500 (Sale price of Rs 100 x 50 – purchase of 80 x 50 – premium of 10 x 50)

If, on the other hand if the price does not fall below Rs 100 until the expiry date, you could just let the contract lapse. In this case, your loss would be equal the premium that you have paid. i.e. Rs 500

Selling Call and put Options

You buy options from the seller called (Option Writer) who is obliged to comply with your decision for which he receive a fee. (The premium you pay to but an option)

If you exercise your option the option writer bears a loss which is the price differential between the spot price and the strike price less the premium income he has earned. However, when you let your option lapse, the option writer’s income is the premium you have paid to buy the option.

Remember the Option writer “return is limited” and “risk is un-limited”.