Call and Put Options: A Guide to Stock Options Trading

An option contract can be a Call Option or Put Option. A call option comes with a right to buy the underlying asset at a pre-agreed price on a future date, and a put option gives you the right to sell the security at a specified price on a specified future date. Simply put - if the price of the underlying stock is expected to go up in value, then you BUY CALL options. Conversely, if the price is expected to go down, then you BUY PUT options. This way, you can buy or sell the underlying stock at a fixed price even if its price goes up or down.

The options seem slightly confusing to many. Let us elaborate on call option and put option to reduce the complexity as they appear.

Investors should know the following three terms to understand the working of an option:

·         Strike price: The price at which the asset will be purchased/sold on future date

·         Premium: The price that an option buyer will pay to take position

·         Expiration: The expiry date of the option

What are Call and Put Options?

Call Options

Call options are contracts that provide the trader with the right, not the obligation, to purchase the security at a pre-defined price on the expiry date. A buyer of call option speculates that the security prices will rise, therefore, they take position at a lower strike price and make profit when the securities’ price rises.

Put Options

Call options are contracts that provide the trader with the right, not the obligation, to purchase the security at a pre-defined price on the expiry date. A buyer of call option speculates that the security prices will rise, therefore, they take position at a lower strike price and make profit when the securities’ price rises.

Call Option in Share Market

Suppose you purchased a call option for 100 shares of company BHEL at Rs.120 per share (strike price) for Sep. 1 (Expiry Date). You can exercise the right to buy the shares at Rs. 120 regardless of the prevailing stock price on  29 JUNE 2023

In the above case, the trader would expect the stock price of company BHEL to rise, thereby allowing them to buy it at a lower cost than its market price. If the market price of share is lower than the strike price locked by the option buyer, they can choose to not exercise the right. They will only lose the premium they paid for the option.

Another example is buying a call option for Rs.200 premium (premium of Rs. 2 per share for 100 shares), which expires in two months. The strike price is Rs.40 per share, and the stock is expected to go to Rs.50 in two months. If the stock price rises to Rs.50 on the expiry date, you can exercise your right and buy the shares at Rs.40 per unit. The special thing about trading in options is that you are not obligated to exercise the contract, so if the share prices do not stay in your favourable range, you can choose not to exercise the contract and the loss on the trade will only be the premium amount you have paid, i.e. Rs. 200.

Selling/ Writing a Call Option

The key consideration for a call option writer/seller is the declining asset price and the option's expiration date. It is used to hedge against a possible drop in underlying stock price. The option seller keeps the premium paid by option buyer as profit. Option seller must pay a higher margin compared to option buyer to take position. The ideal time considered by traders to sell a call option is when the underlying asset price is not expected to rise before the expiration. Call options are sold as:

·         Covered Call Option - When the seller possesses the underlying asset.

·         Naked Call Option - When the seller sells the option without possessing the underlying asset.

Put Option in Share Market

For example, you own 100 shares valued at Rs.100 per share. You analyse that the stock can decline to Rs.90 over the next two months. You invest in a put option with the right to sell those 100 shares at a strike price of Rs.100 on the expiry date, which is two months later. If on the expiry date, the share price falls below Rs.100, you can choose to exercise the option.

Put Option Buying

Buying puts appeals to traders expecting a decline in the underlying asset price. It protects you from losses against a small amount of premium.

You need to choose the strike price first, i.e., the price at which you will sell the asset on the future date. Choose an expiration date.

You can monitor the stock prices to gauge if the option contract is helping you hedge the risks. You can let the option unused if the stock price does not stay in your favourable range. There will be no profit, but your losses will not be more than the option premium.

Put Option selling

Put Option sellers expect a rise in the value of the underlying asset. They have to pay the margin to take position. Also, option seller must settle the daily Mark-to-Market (MTM) basis the change in option prices.

Summarizing Call & Put Options

Thus, the call and put options are the opposite of each other. Where buying a call allows you to buy an underlying security at a fixed price on expiration, when price of underlying is expected to rise. A put option is bought when the asset price is expected to go down and it gives the right to sell the underlying stock at predefined price on expiration.