Options trading popularity has grown dramatically over the last 10 years due to better trading technology for retail traders and an increase in option products like weekly options.
More and more investors are discovering how options can provide access to many more investing strategies than just buying stock and hoping it goes up.
Options can allow you to generate income in a portfolio, protect profits, hedge, and leverage your returns. Another amazing aspect of options is that you don’t just have to buy options but can make money with them as a seller, even if the stock price doesn’t move anywhere.
For most people that are new to options it can be a little overwhelming trying to understand all the terminology and various options strategies.
In this article we are going to simplify the key information you will need to know for getting started investing with call and put options.
Terminology of Calls and Puts Explained
Before getting into the differences between call and put options, every investor should first understand some important option terminology.
Exercise - Exercising an option is when the option owner can decide to buy(for a call option) or sell(for a put option) the underlying asset or just let the contract expire. Different brokerage have different rules about automatically exercising options so investors should understand the rules if they want to exercise their option.
Expiration - The date when the option contract ends. Monthly equity options expire on the third friday of every month and weekly options expire every friday. If the option is out of the money then it becomes worthless at expiration.
In the money - This simply means that the underlying stock has moved past the strike price. The call option is in-the-money if the underlying asset price is higher than the option’s strike price. The put option is in-the-money if the underlying asset price is lower than the option's strike price.
Out of the money - The option has no intrinsic value and will expire worthless if it stays out of the money.
Strike Price - The specific price at which the underlying stock can be bought or sold if the option contract is exercised.
Option Premium - The amount that must be paid by the option buyer to the options seller. The option premium is influenced by several factors which we will cover later on in this article. One option contact is equivalent to 100 shares so an option quoted at $1.50 means it would cost you $1.50x100 = $150.00 to purchase the option.
Calls and Puts Explained
Stock options were first introduced on the Chicago Board Options Exchange(CBOE) in 1973. Simply stated, an option is a contract that gives the option holder the right (not an obligation) to buy or sell an underlying security (stock, ETF, Commodity, Index,etc.) at a specific price by a certain time period.
Not all stocks have options as it is dependent on stocks that trade enough volume and have enough investor interest.
The two types of options are call and puts. For any option contract there is a buyer and a seller and each side has its own risk/reward profile depending on how they are using the option in their portfolio.
Each option contract is tied to a specific underlying security like a stock or index or commodity. Every option has a specific “strike” price and an expiration date which will help determine the option’s value.
Image source: call option graph
For example, a Microsoft call option with a 55 strike and July 2017 expiration would mean that the call buyer can profit when the stock price moves up past $55 strike price and the seller of the call option can profit when the stock price stays below $55. The call option is valid until its specific expiration date in July 2017.
Image source: put option graph
As mentioned earlier, each equity option contract is based on a 100 shares of stock so if you exercised a call option then you would have a 100 shares of the stock placed into your brokerage account provided you had the funds available. If you don’t want the stock then you can close out the position by selling the option or if it is out-of-the-money then you can let the contract expire worthless.
The key thing to understand when buying options is that they give you the right but are not an obligation. This means that you don’t have to exercise options and are not committed to having to buy or sell the underlying stock.
The video below provide a great visual overview explaining call and put options.
Difference Between a Call and a Put?
By now you have a general understanding of how options work but there are some important differences between a call and a put.
A seller of a call is betting that the stock will do down so by selling the call they are exposed to unlimited upside if the stock continued to increase in price. Whereas, a put seller risk is limited by the stock going to zero.
Other than a different risk/reward, call options work similar to put options but they are betting on different outcomes.
Differences In Calls and Puts
What is the difference between a call and a put? It's all summarized in the table below.
Call option gives buyer the right to buy underlying security by specific date at a specific price
Put option gives buyer the right to sell underlying security by specific date at a specific price.
What it Will Allow
Buying of Stock
Selling of Stock
Wants stock price to rise
Wants stock price to fall
Understanding Option Time Value
Time value is a key point that an option investor must understand before ever trading any options because it is one of the biggest factors in why people lose money with options.
Option premium is determined by multiple factors besides just the price of the underlying security. These factors include time until expiration, how volatile the underlying stock is, and how far away the option strike is from the current stock price.
Premium is comprised of Intrinsic Value and Extrinsic Value. Intrinsic is the amount that the option is in the money and extrinsic is the time value component. An easy way to remember the definition of EXtrinsic value is that it is caused by “EXternal factors” like time and volatility.
An Example of a Call Option Premium
December 2016 XYZ 25 call priced at $2.80 when XYZ stock is trading at $27.
This means that a call that is expiring December 2016 with a strike price of $25 is in the money by $2 ($27-25) has an intrinsic value of $2 and and extrinsic value of $0.80 to get to the $2.80 premium price.
Remember, premium is based on probability so the longer the time until expiration or the more volatile the stock then the higher the chance that an option can be in or out of the money. These factors will increase the premiums that options sellers require from buyers because the sellers are taking the risk.
Many new option investors don’t understand time value. They buy “cheaper” out of the money options only to realize that those options lose value faster than the stock can move. Even worse is when the option buyer is correct in predicting the direction of the stock but their option value decreased more than the stock moved so they still lost money.
Options use a statistical pricing model that evaluates all these factors to help determine the statistical likelihood of the option expiring in or out of the money.
The farther out in time that the expiration date is, the higher the option price premium because there is more time for the option to move in the desired direction. Whereas when options get close to expiration you will see the option value decrease especially if it is out of the money because there is less likelihood of the option being in the money.
Misunderstanding time value and option premium factors are probably the biggest reasons that new option investors lose money.
How An Option is Priced
Now that you understand time value, you can get a better understanding of how an option is priced. Option pricing is comprised on factors referred to as “option Greeks” which are Delta, Theta, Gamma, and Vega.
Trying to understand option Greeks is honestly confusing and beyond what we will discuss in this article but there are some basic things that are important to understand about option Greeks. The 2 Greeks we will discuss are Theta and Delta as those are the two you that are most important.
Delta is measured on a scale of -100 to +100 and measures the sensitivity of an option's value to a change in the underlying stock’s price. Basically, Delta will tell you how much a specific option will move for every $1 more in the underlying stock price. Call options have positive delta and put option have negative delta.
The farther in the money an option is the higher the delta. This is because the option has a higher likelihood of staying in the money so it moves more dollar-for-dollar with the underlying stock.
An at-the-money call option(meaning the option strike price is the same as the current underlying stock price) has a delta of only 50. This means that the at-the-money call option has a 50/50% chance of being in the money since the stock can either move up or down.
A call with an 80 delta(or -.80 delta for put option) will increase .80 (or $80) for every $1 increase in (or $1 decrease for puts) stock price.
The delta will constantly change as the underlying stock price changes.
Theta is the measure of time decay in an option. As discussed earlier in this article, time value is a significant component of an option’s value. Theta is a measure of the daily expected amount of premium erosion that will occur from passage of time.
Usually theta doesn’t become significant until you get closer to expiration so if you are buying options then you want to make sure you aren’t buying options that are expiring near term. Also, theta will decay faster the farther out of the money that your option is.
Theta decay is something to consider if you are buying options because the option value can erode while you wait for the stock to move.
Call and Put Options Examples
On May 15th, ABC stock is trading at $50 and has July 45 call options for $6.45 and July 50 call option for $2.85.
There are about 2 months(May 15th until 3rd week of July) until the options expire and you believe the stick will increase.
You can either buy the 45 call which which has $5 in intrinsic value($50-45) and $1.45 in extrinsic time value or buy the $50 call which has Zero intrinsic value and $2.85 in extrinsic time value.
The idea is if the stock moves far enough past $50 then you can make more return on your investment with the $50 calls then you would on the $45 calls, but if the stock doesn’t move then you are exposed to more time value erosion in the $50 calls then the $45 calls.
For put options, since stocks can fall faster than they rise, generally you will see higher extrinsic value priced into put options. This is especially true if the stock made a large move up already or if there is an upcoming announcement like quarterly earnings because there is a higher probability of the stock moving down. Therefore put sellers want to be compensated for taking on the larger risk that the stock could move down.
Using Calls And Puts With Your Investments
Options offer a lot more choices to your investment plan. Here are just a couple call vs put examples of how you could implement options in your portfolio.
Buy Long Term Puts
You have a large amount of your net worth tied up in company stock but can’t sell it due to restrictions. You could buy long term puts to prevent any downside. (It is what Mark Cuban did when he sold his company to Yahoo and owned lots of Yahoo shares).
An even more popular strategy for those that have large amount of company stock they can’t sell is called a “collar trade” where you sell calls that are out of the money to help pay for the cost of your protective puts that you bought.
By selling calls you are limiting your amount of upside in the stock but you are essentially locking in the stock to protect your investment. Eventually you can sell the stock when it is no longer restricted and close out the puts by selling them.
Buy Deep in the Money Long Term Calls
If you want to buy a high priced stock but don’t have the money then you could buy a deep in the money call option that expires far out in time to benefit from the stock increasing over time and only committing a fraction of the money needed vs. buying shares.
Remember - a deep in-the-money call has a high delta so it would move almost a full dollar for dollar with the underlying stock price.
Sell Naked Puts
Say you want to own a stock at lower prices. You could sell puts and collect the premium from selling. If the stock ever drops below the put option strike price then you have the stock put to you at the price you wanted with the added benefit of having collected premium income from selling the puts. (This works great for stock that are basing or not moving as you can sell weekly calls every week for months and collect premium every week)
Those are just some of the simple examples of using calls and puts. There are many more strategies that you can use both as a buyer and a seller of options.
Hopefully this article gave you a good overview about options and the difference between calls and puts.
We touched on the essential components of call and put options so you can take that understanding with you when you start researching how to use options with your investments.
Don’t get overwhelmed by all the technical jargon and complicated options strategies you will find with options. Keep it simple.
Now go out there and start practicing with call and puts until you feel comfortable implementing options trading for real in your investment accounts.