Puts and calls are short names for put options and call options. When you own options, they give you the right to buy or sell an underlying instrument. You buy the underlying at a certain price, called a strike price, and you pay a premium to buy it. The premium is the price of an option and it depends on its expiration, implied volatility, dividend date, interest rate and on a distance of the strike price from the market price of the underlying.
What is a put option?
A purchase of a put option allows you the right to sell the underlying at a strike price. You can use puts to protect a long position from a price decline, but you can also use them even if you don’t own an underlying.
Here’s an example: Apple Inc. currently trades at $186.87. One put option in Apple with a strike of 185 and the July 6 expiration costs around $3 per share and it covers 100 shares. You’ll have to pay $300 for one put. And, if you do that, your long position in Apple will be protected until July 6. With the purchase, you would limit your potential loss to $4.87 per share until July 6.
Do the math by adding the premium of $3 to the difference between the market price and the strike of the put. If Apple closes at $180 on July 6, you’ll exercise the option. This means that you are going to use the right to sell Apple at $185 and instead of losing $7, you’ll only lose $4.87. If Apple closes at $190 on July 6, your total profit would be $0.13, because you would make $3.13 by owning shares and you would lose the premium you paid for the insurance.
Long Stock, Long Put Payoff
Above is an example of a put option that is almost $2 below the market price. If you want to buy the put whose strike equals the market price, you would have to pay a higher premium. The July 6, 187.50 strike put in Apple costs around $4. You have probably noticed that the strike is not the same as the market price. This is because the example uses exchange-traded options. The exchange-traded options are standardized, so they don’t have a strike price for every market price. To get this, you would have to go off-exchange and buy an over-the-counter option. There are brokers that specialize in this type of trading and offer such contracts.
You don’t have to own the stock to trade puts. You could buy the July 6, 185 strike put, without owning shares of Apple. If in a week the stock trades to 185, your put would be worth more than $3 and you could sell it with profit. You can use this calculator to get the value of a put with 29 days till expiration and with the underlying market price of $185. The simulation shows that the price of the put would jump to $3.60, which means 20% profit on your trade.
You can trade puts like that even if you own the stock, but you won’t get a full compensation for the move of the underlying. In this example, the put gained only $0.60 and the stock lost $2. Your option had a delta of -0.4 when you bought it, which means that it gains 0.4 if the stock declines $1. It also had a theta of -0.05, which means that it loses 0.05 as one day passes. When the stock declined to $185, our simulation showed that put’s delta dropped to -0.5.
Investors can also use puts to generate income. If you sell a put, instead of paying a premium, you receive the premium and if the option expires worthless you make a profit. So in the example, when you paid $3 for the July $185 put and the stock closed at $190 on July 6, the seller collected $3. When the price dropped to $180, the seller of the put had to buy the underlying for $185, but his or hers net price was $182.
What is a call option?
A purchase of a call option gets you the right to buy the underlying at the strike price. Instead of owning a stock, you can buy a call option and participate in a potential upside. Your potential loss is limited to the paid premium and you get unlimited upside potential.
If you want to buy the July 6, 190 strike call in Apple, you would have to pay around $2.80 and you would profit if the stock trades above $192.80 at the July 6 expiration. If Apple closes at $200 on July 6, you exercise the call and buy the stock at $190. Your net price would be $192.80, but you could sell it immediately for $200 and make $7.20 per share. You could choose a different strategy and trade the call you bought before the expiration. Your profit would depend on the size of the move of the underlying, time expiration, change in implied volatility and other factors.
Long Call Payoff
Just like the put, you can sell calls and generate income. If the price moves against you, you would have to sell the stock to the buyer of a call. If you don’t already own it, you would have to borrow shares and take a short position.
Another popular strategy using calls is a covered call strategy. In this strategy, you own the stock and you sell a call against it. Your selling price is fixed or limited to the sum of the strike of the call and a premium collected, but on the other hand, the premium provides you protection.
Similarities between puts and calls
- Used for hedging. Puts and calls can be used for hedging. A trader with a long position, concerned about a possible market decline, is going to buy puts, while a trader with a short position, concerned about a sudden price increase, is going to buy calls.
- Value decays with time. Puts and calls are sensitive to the time expiration. We use theta to measure how much an option is going to lose with an expiration of one day.
- Sensitive to a change in implied volatility. Implied volatility is expected volatility of the underlying and we use vega to calculate how much is an option going to change with a one percent increase in implied volatility. Higher implied volatility means a higher price for puts and calls and vice versa.
- Used for long and short positions. If you buy a call you have a long position that should make money in case of an increase in price, but if you sell a call you can lose money in case of a price increase. Traders who own puts have a bearish position and they can make money if the price declines. When we sell puts, we can lose money when price declines.
Differences between puts and calls
- React differently to a change in the underlying price. We use delta to measure how much the price of an option changes in case of a $1 change in an underlying. Calls have a positive delta which means that they increase in value with an increase in stock price, while puts have a negative delta and they decrease in value with a positive change in an underlying.
- React differently to a change in interest rates. We measure the effect of a change in interest rates on the price of options with rho. Calls increase in value with higher interest rates, while puts decrease in value.
- React differently as the dividend date approaches. Calls lose value as we get closer to the dividend date, while puts increase in value.
- Strike differently affects the value of an option. Calls with a lower strike have a higher value than calls with a higher strike, while puts with a lower strike have a lower value than puts with a higher strike.
Puts and calls can be a useful tool for investors and traders. They can offer protection, leverage and a possibility for a higher profit, but they can also be very dangerous when they are not used properly. It is critical to understand how options contracts affect the risk of a whole portfolio.