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Understanding Call and Put Options for Beginners

W hile options can be traded like stocks and bonds, these investments have distinct features that can present a challenge for first-time investors. As derivative investments, the premium prices of options rise and fall based on the price fluctuations of their underlying assets. For example, if the underlying asset is a stock, the option premium price will rise when the stock price rises and drop when the stock price drops.

Taking advantage of these price fluctuations can result in a significant profit, but it carries a high risk for inexperienced and seasoned traders alike. If you’re ready to start trading options for the first time, this guide will explain the concepts you need to get started.

  • Call and put options let you benefit from the price movements of a stock or exchange-traded fund.
  • Call options give you the right to buy a stock or ETF at the strike price, even if the stock’s value rises above that price.
  • Put options give you the right to sell a stock or ETF at the strike price, even if the stock’s value drops below the strike price.
  • Trading options allows you to limit your stock market risk while potentially taking advantage of downturns or upturns in prices.

What Are Call and Put Options

When you buy an options contract, you are purchasing the right to buy or sell 100 shares of a stock, index, or financial product (the underlying asset) by a specific date at a certain price, referred to as the ‘strike price.’ Call options give you the right to buy these shares, while put options give you the right to sell them. Trading stock options is always more affordable than purchasing shares of the stock itself.

Although options represent legally binding contracts, you do not have an obligation to go through with the purchase. You can choose to let the contract expire instead. If you expect the price of the underlying asset to go up before the option expires, you should place a call option. In comparison, if you expect the underlying asset to go down in value before your option expires, you can place a put option.

How Do Call Options Work?

If you’re unsure whether you want to buy an asset or not, you can instead purchase the call option . As described above, this option lets you purchase the shares at the strike price anytime before the option expires. The strike price associated with an option is the set price at which it can be traded if you exercise it. This allows you to profit from the shares if the price goes up or step out of the deal without further loss if the asset’s price declines.

For example, you might purchase a call option for $2 with a strike price of $10. The stock’s current value is $10 and goes up in price to $20 within the expiration period. You can exercise your option to buy the $20 shares at the $10 strike price, which will make you a profit down the line. Now, let’s say the stock price goes down to $5 instead. You can allow the option to expire and lose only the $2 call option premium you paid for each share.

When a call is ‘in the money,’ the premium is the highest because the price of the underlying asset has already exceeded the strike price, creating intrinsic value. However, you can also buy a call option ‘at the money,’ which means the strike price and asset price are equal, or ‘out of the money,’ which means the strike price exceeds the price of the underlying asset.

How Do Put Options Work?

With a put option, you have the right, but not the obligation, to sell shares of an underlying asset at a specific price by a certain date. This type of option locks in your sale price until it expires, so it’s a good strategy if you think the price of the underlying asset will fall over the next several days or weeks.

With this type of strategy, you purchase a put option to limit risk while taking advantage of falling stock prices. Buying put options protects you from the high risk associated with changing stock prices because your option contract expires as soon as the stock price dips below the strike price. You risk only the premium you paid for the option.

Let’s return to the example above. This time, you purchase a put option for $2 with a strike price of $10. The stock’s current value is $10 and goes down in price to $5 within the expiration period. You can exercise your option and force the buyer to purchase the designated shares at the higher strike price. If the stock value goes up instead, you can allow the option to expire.

What Strategies Can Be Used To Trade Call and Put Options for Beginners?

Image via Flickr by bfishadow

Learning a few basic trading strategies can help you optimize the impact of options investments.

The Protective Put

A protective put is a risk-management strategy that offers protection against a short-term decline. For this strategy, you purchase put options for a stock you already have in your portfolio. The goal is to cover the loss you would experience if the underlying stock value decreases rather than increases. As a result, many investors use this type of strategy as insurance against financial risk.

The Covered Call

This strategy makes sense when you want to use options to add volatility protection to your portfolio. Choose a covered call when you expect the asset price to remain steady or rise slightly.

With a covered call, you first purchase 100 shares of the asset in question, then sell a call option against those shares. If the investor sells the call option, they get the premium, and you get the assurance that the underlying stocks you purchased will sell for a profit.

This strategy can backfire if the share price exceeds the strike price before the call option expires. With this scenario, you will have to sell your stocks at the strike price, even if the market value is higher. However, some traders accept this risk in exchange for the integrated protection offered by a covered call. With an uncovered call, if the stock price exceeds the strike price and you don’t own the underlying asset, you must purchase the required shares on the open market at the new, higher price before selling them at the strike price.

The Long Strangle Strategy

With this strategy, you purchase a put option as well as a call option that is out of the money. These options should have different strike prices but the same expiration date, with a higher call strike price than the put strike price.

The Long Straddle Strategy

With this strategy, you purchase a put option at the same time that you purchase a call option on the same underlying asset. These options should have the same strike prices and the same expiration date. The strike price should be at the money or close to it. Like a long strangle strategy, the long straddle lets investors take advantage of large moves in the price of a stock (either up or down).

The Protective Collar Strategy

To take advantage of this strategy, purchase a call option for an out-of-the-money stock as well as a put option for the same stock that is also out of the money.

The Married Put Strategy

This strategy acts as a shield against short-term losses. To make it work for you, buy a stock and then purchase put options for the same number of shares. This should help protect against the risk of the stock’s price depreciating. After that, sell an identical number of call options with a higher strike price.

Why Invest in Call and Put Options for Beginners?

Sophisticated stock market investors know about the advantages of options, but novices can unlock these secrets, as well. There are many reasons you might want to think about expanding your portfolio to include put and call options, such as to:

  • Achieve a new income goal.
  • Protect the rest of your portfolio against market fluctuation.
  • Speculate about the market direction.
  • Leverage the ability to profit in flat, bear, and bull markets.
  • Generate a stream of steady income from your existing blue-chip portfolio.
  • Invest in a specific asset without having to meet a high minimum for that asset.

In some cases, successfully exercising a call or put option can give you a 200% or 300% return within just a few days. Using this guide will help you get off on the right foot if you’re new to the world of options trading.