What Are Put Options and Call Options?
Before we jump into the two option types, let’s first look at what an option is.
Definition of an Option: The right (or option) to either buy or sell a stock at a specified price on or before a specified date. If the option is not exercised by that date, then the option will expire. The right is secured by the payment of a premium.
Call options are purchased by the potential buyer from the potential seller. The buyer pays the seller a premium for the right to buy the stock on or before a certain date. This can be a great safety net for an investor.
Say the investor buys a 40 call option for 1,000 shares with an expiration date in April. If the price is 45 by the time the April rolls around, then the investor can spend $40,000 to buy $45,000 worth of stock. Once they’ve subtracted the premium for the option and broker commissions, they’ve got a pretty good rate of return instantly. The same option can also be exercised any time during that time period. So if the price hit 55 in March and looked like it was going to peak, the investor could exercise the call option before the expiration date, getting shares for substantially below market value.
While a call option works out well if the price goes up, it also has built in protection if the stock goes down. Say the same stock in the call option above drops to 30 when April arrives. It would be very foolish for the investor to buy the stock at 33% above market value. In that case, the investor would simply let the option expire. If they had originally bought the stock at 40 instead of the option, they would have a loss of $10,000. Instead they only loss they have is the cost of the premium for the option.
A put option is the reverse of the call option. Instead of purchasing the right to buy stocks at a specific price, you’re purchasing the right to sell stocks at a certain price. With a call option, you want the price of the stocks to go up so you can buy stocks at below market value. With a put option, you want the price to go down so you can sell them above market value.
This is where it gets complicated, though. When you purchase a put option, you don’t do it for stock that you currently own. The whole point of an option is to give you an advantage over the market price. So instead, you buy the stocks you’re going to sell when you exercise your option.
Lets take the above example, but with a put option of 1,000 shares at 40 instead of a call option. If the price goes up to 45 in April, then the investor would be forced to spend $45,000 for shares that they would sell for $40,000. Instead, the investor with the put option would simply let the option expire.
But it’s a different story if the price goes down to 30. Then the investor would spend $30,000 to buy stocks that he would turn around and sell for $40,000. Like the call option, the investor is buying the opportunity to possibly make money on an investment in the future, while only risking the cost of the premium.