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Review Call and Put Option Examples

E xperienced traders often take advantage of derivative securities, investments that move in price depending on the price of another asset, called the underlying asset. Call and put options are two of the most common types of derivative investors to understand before diving deep with this strategy. Reviewing an example of a call and put option can give you insight into how this trading strategy works and help you figure out if it’s the right approach for you.

Key Takeaways:

  • Call and put options are common derivative securities. These assets change in price as an underlying stock or asset changes in price.
  • A put option strategy takes advantage of an asset you expect to drop in price.
  • A call option strategy takes advantage of an asset you expect to rise in price.
  • Studying call and put options examples can help you put this strategy to good use.
  • With options, you reserve the right to buy or sell a specific stock at a specific price, called the strike price, before a specific date.
  • Options do not carry an obligation to buy or sell, which limits both potential loss and potential profit.
  • Hedging against risk, covered calls, spreads, and speculating on the potential rise or fall of the underlying asset are the most common strategies used with call and put options.
  • You can buy call and put options from your brokerage firm after receiving approval based on your knowledge of these derivative securities.

Call and Put Option Example

An option is a type of contract in which you pay a premium price in exchange for the right to sell or purchase the underlying asset on a specific price, called the strike price, by a specific date. If you decide not to do so, the option simply expires.

You can buy a call option if you think the underlying asset will go up in value by the expiration date. A put option makes sense if you think the underlying asset will fall in value before the expiration date.

Now that you know the call and put option definition, let’s look at a put and call option example.

Pretend you’re purchasing a call option with a strike price of $10. The underlying asset has a current stock value of $8, which increases to $14 before your expiration date. You decide to exercise your option to buy the designated number of shares of the underlying asset at $10 each. You can either hold on to those shares in the hope that they climb even higher, or you can sell them right away for a tidy profit of $4 per share.

Now let’s say you decide to buy a put option, also with a $10 strike price, after the stock rises to $14. You think it will peak and then drop back down again before the put option expires. Your prediction comes true and the price of the underlying asset hits $5. You exercise your option and require your buyer to purchase the contracted number of shares at $10 each for an instant profit of $5 per share.

How Call and Put Options Work

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If you purchase a U.S.-style option, you can exercise your right to buy or sell the underlying asset at any time until the option expires. European-style options can be exercised on the day of expiration, not before. Options contracts have varying expiration dates, with both long-term and short-term options available.

When you buy a single call or put option, it covers 100 shares of the underlying asset, with the stock price listed per share. Traders say an option is at the money when the strike price equals the stock price. A stock price below the strike price is called an in-the-money option. The term ‘out of the money’ describes an option in which the stock price exceeds the strike price. An in-the-money call or put option has the highest premium cost.

Benefits of Call and Put Options

The primary advantage of call and put options is the limited risk associated with these securities. You cannot lose more than you spend on the premium cost for the option. If you decide not to use the option, it expires without penalty.

Here’s another call option scenario:

  • You pay $200 for a call option contract. This gives you the right to buy 100 shares of the underlying asset. The strike price of the option is $40.
  • When the option expires, the underlying asset is trading $50 per share. Thanks to your call option, you can buy 100 shares at $40 each, or $400. You can then immediately sell them at the $50 market price to make $5,000.
  • Your profit is $1,000 minus your $200 option cost. This represents a 400% percent return on your original investment.

Consider how you can use this put option example in a declining market:

  • You have an index portfolio and feel bearish about its prospects. You want to ensure that you can retain 90% of its value, which is currently $4,000.
  • You buy a put option that allows you to sell the portfolio for $3,600 with an expiration date of 12 months in the future.
  • If the value of your portfolio drops, you only lose $400 plus the cost of the premium if you exercise your option.
  • If the value of your portfolio ends up increasing, you let the option expire without action and lose only the premium cost.

Strategies for Call and Put Options

Traders can take advantage of various strategies when it comes to call and put options. Some of the most common strategies include:

  • Hedging against loss in other investments. For example, you can use a call or put strategy to take advantage of price moves in an underlying asset that you own. If a stock declines in price, a put option can offset losses.
  • Speculating with options on a stock price that’s expected to increase. In this case, you can either sell a put option or buy a call option. Purchasing a call option limits risk to the premium cost and carries potentially unlimited profit. Selling a put option, on the other hand, limits profit to the premium price and carries unlimited potential loss.
  • Speculating with options on a stock price that’s expected to decrease. In this case, you can either buy a put option or sell a call option. When you sell a call, you limit your profit to the option premium. When you buy a put, you limit your loss and create potentially unlimited profit.
  • Establishing a covered call in which you already hold a long position on an underlying asset. You protect that asset by selling a single call option for every 100 shares you own. If your asset fluctuates only slightly, you can profit from the call option sale.
  • Using spreads in which you buy two different positions in the same options class. This strategy is used to shield funds against risk while potentially profiting from your prediction about the market direction.

How To Buy Call and Put Options

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When you buy an option contract, you are generally purchasing the right to buy or sell 100 shares of the underlying asset. The underlying asset can be a stock, a bond, an index, an exchange-traded fund (ETF), or another type of security. Options are available from most traditional brokerage firms as well as many online brokers.

Before purchasing options from a traditional brokerage firm, you must receive approval from your broker. The broker will ask you to complete a short form that evaluates your knowledge about options trading. After approval, you can trade call and put options on the open market as well as over-the-counter options deals that take place off the market between a buyer and a seller.

C all and put options allow you to benefit from market volatility while limiting risk. Reviewing each call put option example boosts your knowledge of this advanced market tactic. Many traders even use mathematical models to maximize their potential options profits.