If you’ve ever wanted to learn to how to trade options, you probably were overwhelmed at first. However, what if I told you it’s not too difficult to trade options once you learn the basics. When you’re learning how to trade options, you need to build intuition and gain experience over time to become a successful options trader. That said, let’s start off with the basics and learn the differences between call options and put options.
How to Trade Options – Calls vs. Puts
Before we go over the differences between calls and puts, you need to learn what an option is. An option contract is an option to buy or sell an underlying asset, which could be a stock, index, futures or commodities. An equity option, or stock option, contract is just a choice about whether you want to buy or sell shares of a stock at a specified price, on or before a specific date.
There’s one crucial factor to take into account when trading options. If you buy an options contract, your maximum loss is limited to the amount of premium paid. Conversely, when you sell short, or write, an options contract, you would receive a credit. However, when you write options, your risk is theoretically unlimited.
Now, let’s take a look at the differences between call options and put options.
Call Options vs. Put Options
A call option gives you the right to buy the underlying stock at the specified strike price, on or before the expiration date. Conversely, a put option gives you the right to sell the underlying stock at the strike price on or before the expiration date. When you’re buying 1 call option or 1 put option, you pay a premium to receive the right to buy or sell 100 shares of the underlying stock, respectively, and you’re not obligated to do so. That said, the amount of premium you paid is the maximum amount you could lose. However, if your option expires in-the-money, you would automatically be exercised.
In order to receive the right, but not the obligation, to buy or sell the underlying stock at a specified price any time on or before the expiration date, the owner pays the seller, or writer, the option premium. If you buy a call option, and the underlying stock increase significantly, you would have unrealized profits. On the other hand, the writer of the call option would suffer.
On the other hand, if you buy a put option, and the underlying stock falls significantly, you would have unrealized profits.
Options Payoff Diagrams
When you’re trading options, you need to know how your profit and loss will look like at expiration. Here’s a look at the payoff diagram for call options.
Notice how your downside is capped to the premium paid. On the other hand, if the underlying stock explodes, you would have unrealized profits.
Here’s a look at an example of a put option payoff diagram at expiration.
Writing Options is Risky
Now, the writer of an options contract takes the opposite side of risk and receives a premium. However, the writer of an options contract is obligated to deliver shares of the security if they are exercised, or if the options contract expires in the money.
Again if you write options, you would receive a premium for taking on the risk. If you sell short, or write, a call option, you are obligated to sell shares of the underlying stock if the call option holder exercises the option, or if the option expires in the money. If you write a put option, you are obligated to purchase shares of the underlying stock, if the put option expires in the money or the holder exercises the option.
Keep in mind that naked writing options, or selling without hedging the options, is extremely risky. You shouldn’t look to write options when you’re first starting out. Moreover, you’re going to need some collateral if you’re looking to write options to collect premium.
When you’re learning how to trade options, you need to understand the basics. The first thing you should understand is the difference between call options and put options. Moreover, you need to understand the fact that when you write options, it’s extremely risky. That said, you should focus primarily on buying options when you’re first starting to learn how to trade options.
Jeff Bishop is lead trader at WeeklyMoneyMultiplier.com and widely recognized as the Mensa Trader. He runs short-term trading strategies, using stocks, options and leveraged ETFs.