Call options and put options are two types of financial instruments that are commonly used in options trading. They allow investors to speculate on the price movements of various underlying assets, such as stocks, bonds, and commodities, without having to own the underlying assets themselves. In this article, we will explore the key differences between call options and put options and how they can be used in options trading strategies.
What are call options?
A call option is a contract that gives the holder the right, but not the obligation, to buy an underlying asset at a predetermined price (known as the strike price) within a specified period of time. The holder of a call option is said to have a long position in the option, as they stand to benefit if the price of the underlying asset increases.
For example, let’s say that an investor purchases a call option for XYZ stock with a strike price of $50 and an expiration date of three months from now. If the price of XYZ stock increases to $60 before the expiration date, the investor can exercise the option and buy the stock at the strike price of $50, even though the market price is $60. The investor can then sell the stock on the open market for a profit.
If, on the other hand, the price of XYZ stock remains below the strike price of $50, the investor may choose not to exercise the option and allow it to expire worthless. In this case, the investor would lose the premium paid for the option.
What are put options?
A put option is a contract that gives the holder the right, but not the obligation, to sell an underlying asset at a predetermined price (known as the strike price) within a specified period of time. The holder of a put option is said to have a long position in the option, as they stand to benefit if the price of the underlying asset decreases.
For example, let’s say that an investor purchases a put option for XYZ stock with a strike price of $50 and an expiration date of three months from now. If the price of XYZ stock decreases to $40 before the expiration date, the investor can exercise the option and sell the stock at the strike price of $50, even though the market price is $40. The investor can then buy the stock back on the open market at the lower price of $40 and make a profit.
If, on the other hand, the price of XYZ stock remains above the strike price of $50, the investor may choose not to exercise the option and allow it to expire worthless. In this case, the investor would lose the premium paid for the option.
Differences between call options and put options
The main difference between call options and put options is the underlying market expectation of the investor. Call options are used when an investor expects the price of the underlying asset to rise, while put options are used when an investor expects the price of the underlying asset to fall.
Another key difference between call options and put options is the potential profit and loss. With a call option, the potential profit is unlimited, as the price of the underlying asset can continue to rise indefinitely. However, the potential loss is limited to the premium paid for the option.
With a put option, the potential profit is limited to the difference between the strike price and the market price of the underlying asset, as the price of the underlying asset can only fall to zero. However, the potential loss is also limited to the premium paid for the option.
Finally, the pricing of call options and put options also differs. Call options are generally more expensive than put options, as investors are willing to pay a premium for the right to buy an underlying asset at a predetermined price, especially if they expect the price of the underlying asset to rise.