Investors can use options to hedge their portfolios against loss. Also, they can help buy a stock for less than its current market value and increase gains. Call vs. put options is the two sides of options trading, respectively allowing traders to bet for or against a security’s future. It’s important to analyze how each works and when you may want to consider investing based on opportunity and overall risk factors. If you’re looking for more direct investment advice for your unique situation, a financial advisor can help you create a financial plan or manage your asset allocation.
What Is a Call Option?
A call gives investors the option, but not the obligation, to purchase a stock at a designated price (the strike price) by a specific time frame (the expiration date). Essentially, the buyer of the call has the option to purchase the security up until the expiration date. The seller of the call is also known as the writer. The writer may sell the security at the strike price until the expiration date.
A call option may make a good investment for an investor if they anticipate the rise of a stock’s price. This would then mean they would receive the stock at a discounted rate. However, if the stock price drops below the call option, it may not make sense to execute the transaction.
Investors use call options to capitalize on the upside of owning stock while minimizing the risk. For example, let’s say an investor bought a call option of Stock ABC for $20 per share and has the right to exercise the transaction for up to two months. The writer may exercise this option for $20 up until the expiration date, even if the stock price increases.
What Is a Put Option?
Conversely, if an investor purchases a put option, they have the right to sell a stock at a specific price up until an expiration date. The investor who bought the put option has the right to sell the stock to the writer for their agreed-upon price until the time frame ends. However, the investor is not obligated to do so.
Purchasing a put option is a way to hedge against the drop in the share price. So, even if the stock price declines on a put option, they can avoid further loss. The investor could also profit from a bear market or dip in the prices of the stocks.
Call Option vs. Put Option
An investor who buys a call seeks to make a profit when the price of a stock increases. The investor hopes the security price will rise so they can purchase the stock at a discounted rate. The writer, on the other hand, hopes the stock price will drop or at least stay the same so they won’t have to exercise the option.
With a put option, the investor profits when the stock price falls. In this case, the put increases as the stock decrease in value. So, while the investor hopes the stock price dips, the writer hopes it increases or stays the same, so they don’t have to exercise the trade.
When buying a call option, the buyer must pay a premium to the seller or writer. But the investor doesn’t have to pay the market margin money before the purchase. However, when selling a put option, the seller must deposit margin money with the market. This then provides the advantage to keep the premium sum on the put option.
In regards to profitability, call options have unlimited gain potential because the price of a stock cannot be capped. Conversely, put options are limited in their potential gains because the price of a stock cannot drop below zero.
Risks of Call Options and Put Options
It’s important to understand the risks of any investment before taking the plunge so that you know what the potential might be. The risk is different for both a call or put option so it’s equally important to distinguish between the two to really understand how each is used and where you might allocate your investment funds.
Call Option Risks
The biggest risk of a call option is that the stock price may only increase a little bit. This would mean you could lose money on your investment. This is because you must pay a premium per share. If the stock doesn’t make up the cost of the premium amount, you may receive minimal returns on this investment. For example, if a stock was trading at $60 per share and you predict it will rise, you may decide to purchase a call option at $63 a share for 100 shares, with a premium of $1.75 per share.
If the stock price only goes up to $65 a share and you executed your option, it would be worth $6,500. This would only result in a $25 gain because you must subtract the premium amount from your total gain ($6,500-$6,300-$175=$25). But if you purchased the shares outright you would have gained $500.
Put Option Risks
With a put option, you’re essentially managing the risk in your portfolio. So, let’s say you have 100 shares of Stock ABC currently worth $100 and you think the price will fall. You may purchase a put option with the right to sell at $100 a share. If the price drops to $90 per share you can exercise this option. This means instead of losing $1,000 in the market you may only lose your premium amount.
Keep in mind that the examples above are a very high-level representation of each major risk. Options trading can become a lot more complex depending on the specific options an investor chooses to purchase.
Bottom Line
Simply put, investors purchase a call option when they anticipate the rise of a stock and sell a put option when they expect the stock price to fall. Using call or put options as an investment strategy is inherently risky and not advised for the average retail investor. If an investor trusts that the price of a stock will move and is ready to invest and accept the potential risk, they may reap substantial returns. If you aren’t sure what trading level you’d meet or how much risk you’re willing to take on, it may be time to talk to a financial professional. They can help you figure out those details and weigh the benefits and risks of put options against similar alternatives.
Options Tips
- A financial advisor can help you put an investing plan into action. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Do you know what kind of investment risk you can tolerate? What will your investment look like years from now? How much will taxes and inflation take out of your investment? SmartAsset’s investing guide can help answer some of these initial questions.
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