Understanding The Basics: Call And Put Options

By Author: ankjhonson
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In the world of financial trading, options hold a place of prominence. Two types of options dominate the trading landscape, namely call options and put options. Understanding what is a call option and the mechanics of put options can prove invaluable for investors navigating this complex market.
Section 1: A Primer on Options
Options are a type of derivative financial instrument that provide the buyer the right (but not an obligation) to buy or sell an underlying asset at a pre-determined price, before or on a specific date. The underlying asset can be diverse, ranging from stocks and bonds to commodities and more.
Section 2: Call Options Demystified
A call option offers the buyer the right, without the obligation, to purchase an underlying asset at a predetermined price (known as the strike price) on or before a certain date. To avail this right, the buyer pays a premium ...
... to the option seller.
When an investor buys a call option, they can potentially profit if the underlying asset's price increases beyond the strike price before the option's expiration. In such a scenario, they can exercise the option, buying the asset at the lower strike price, even when the market price is higher.
Consider this example: An investor buys a call option for 100 shares of Infosys at a strike price of Rs. 1,000 per share, with a premium of Rs. 10 per share. If the Infosys shares rise to Rs. 1,100 per share within a month, the investor can exercise the option, buying the shares at Rs. 1,000 and making a profit of Rs. 10,000. However, if the share price falls below Rs. 1,000, the investor won't exercise the option and loses the premium paid, i.e., Rs. 1,000.
Section 3: Unraveling Put Options
Contrarily, a put option offers the buyer the right, without the obligation, to sell an underlying asset at a predetermined strike price on or before a specific date. Here too, the buyer pays a premium to the option seller.
The buyer of a put option can profit if the price of the underlying asset drops below the strike price before the expiration date. They can then exercise the option, selling the asset at the higher strike price, even when the market price is lower.
Take for instance, an investor buys a put option for 100 shares of Infosys at a strike price of Rs. 1,000 per share, paying a premium of Rs. 10 per share. If the Infosys shares fall to Rs. 900 per share within a month, the investor can exercise the option, selling the shares at Rs. 1,000 and making a profit of Rs. 10,000. However, if the share price rises above Rs. 1,000, the investor will not exercise the option and lose the premium paid, i.e., Rs. 1,000.
Section 4: Trading Call and Put Options
Options, both call and put, can be traded on exchanges like the NSE and BSE. To do so, you need to have a trading account with a broker.
When you trade options, you essentially speculate on the future price of the underlying asset. If you predict the price of the asset to rise, you buy a call option. Conversely, if you anticipate the price to fall, you buy a put option.
The profit or loss from options trading depends on the movement of the underlying asset price relative to the option's strike price. You stand to gain if the price moves favorably, and lose if it moves against your prediction.
Section 5: Risks Involved in Trading Options
Trading options carry risks. For call options, the maximum loss is limited to the premium paid. For put options, the maximum loss is the premium paid plus the difference between the strike price and the market price of the underlying asset on the expiration date.
While options trading can be profitable, it is crucial to understand the associated risks. As a rule of thumb, only trade options with money you can afford to lose.
Conclusion: Harnessing the Power of Options
Call options and put options are complex financial instruments that allow investors to speculate on future asset prices. While they hold the potential for significant returns, they also come with risks. Thoroughly understanding these instruments can empower investors to make informed and potentially rewarding decisions.