What is the Difference Between Put Option and Call Option?
Options are the derivatives that allow a trader to buy or sell an underlying asset before expiration date at a predetermined rate. There are further two types of Options including put and call option that differ on the basis of stock market conditions. While we will learn about these two in detail, we will also discuss the difference between call option and put option.
Table of Contents
- Difference between Put Option and Call Option
- What are Options?
- What are Call Options?
- What are Put Options?
- Key Components of Call Option and Put Option
Difference between Put Option and Call Option
Call Option and Put Option are two types of options that are exercised by traders to make profit. While call options are exercised by bulls in the market, put options are exercised by bears in the market. Let us now learn more about the difference between call option and put option.
| Parameter |
Call Option |
Put Option |
| Definition |
Holder has the right to buy an asset at a specified price within a certain period. |
Holder has the right to sell an asset at specified price within a certain period. |
| Market Outlook |
Bullish (expecting the price of the underlying asset to rise). |
Bearish (expecting the price of the underlying asset to fall). |
| Purpose |
Holder makes profit from increase in the price of underlying asset. |
Holder makes profit from decrease in the price of underlying asset. |
| Strike Price |
The price at which holder can buy the asset. |
The price at which holder can sell the asset. |
| Profit Scenario |
When the underlying asset's price is above the strike price at expiration. |
When the underlying asset's price is below the strike price at expiration. |
| Risk |
Maximum loss = premium paid |
Maximum loss = premium paid |
| Breakeven Point |
Strike price + premium paid |
Strike price - premium paid |
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What are Options?
Options are financial derivatives through which the buyer has the right to trade (buy or sell) an underlying asset at specified price (strike price) before a specified expiration date. There is no obligation to trade an asset. Options are used for hedging purposes, to speculate on the future price of an asset, or to generate income. They are traded on exchanges or over-the-counter and might be based on underlying assets, such as stocks, bonds, commodities, and currencies.
What are Call Options?
Call options are financial contracts that provide the buyer with the right to buy an underlying asset at predetermined price (strike price) within a specified time period. The seller of the call option will have to sell the asset at strike price in case the call options' buyer decides to exercise the option.
How Do Call Options Work?
- Buying a Call Option: Whenever you are buying a call option, you are speculating that the price of that underlying asset will rise above the strike price before the expiration date. You pay a premium to the seller for this right.
- Exercising the Option: In case the price of underlying asset increases more than the strike price, you will be able to exercise the option to buy that asset at lower strike price. You will then earn a profit based on the difference.
- Selling the Option: Instead of exercising the option, you might choose to sell the call option itself if its value has increased due to the underlying asset's price rising. This way, you can realize a profit without actually buying the underlying asset.
- Option Expires: In case the price of underlying asset does not increase than the strike price before expiration date, the call option will expire worthless. Your maximum loss in this scenario is the premium paid for the option.
Understanding Call Options With An Example
Say you are a bullish trader for Company ABC. The company is currently trading at 100 rupees per share. You have bought a call option at the strike price set at 110 rupees. This will expire in three months, paying a premium of 5 rupees per share. If the stock price rises to 120 rupees before this option expires, you can exercise your option for buying shares at 110 rupees and then selling them immediately in the market for 120 rupees. You will be able to make a profit of 10 rupees per share (reduce the initial 5 rupee premium).
Risks and Considerations
- The primary risk of buying call options is that the option could expire worthless if the underlying asset's price does not exceed the strike price, resulting in a total loss of the premium paid.
- Call options can offer leverage, allowing for a potentially high return on investment if the underlying asset's price moves favourably. However, this leverage also amplifies the potential for loss.
What are Put Options?
Put options are a type of financial derivative that give the buyer the right, but not the obligation, to sell a specific amount of the underlying asset at predetermined price within a specified time period. Conversely, the seller of the put option will have to buy the asset at strike price in case the put options' buyer decides to exercise the option.
How Do Put Options Work?
- Buying a Put Option: Whenever you are buying a put option, you are speculating that the price of underlying asset will fall below the strike price before the expiration date. The premium is paid upfront to the option seller.
- Exercising the Option: In case the price of this underlying asset remains less than the strike price, you can exercise this option for selling the asset at higher strike price, potentially earning a profit based on the difference.
- Selling the Option: Alternatively, if the value of the put option increases because the underlying asset's price has fallen, you might choose to sell the put option itself to realize a profit without actually selling the underlying asset.
- Letting the Option Expire: In case the price of underlying asset does not go down below the strike price before expiration date, the put option will expire worthless. In this scenario, your maximum loss is the premium paid for the option.
Understanding Put Options With An Example
Suppose you believe that Company ABC. It is currently trading at 50 rupees per share. Say, it is going to decrease in price. You have bought a put option with strike price set at 45 rupees. It is going to expire in three months, for which you will pay a premium of 2 rupees per share. If ABC's stock price drops to 40 rupees before the expiration date of the option, you can exercise your option to sell shares at 45 rupees, even if their market price is 40 rupees. In short, you will be making a profit of 5 rupees per share (reduce the premium of 2 rupees).
Risks and Considerations
- The primary risk of buying put options is that the option could expire worthless if the underlying asset's price does not fall below the strike price, leading to a total loss of the premium paid.
- Put options can be used for speculation or as an insurance to hedge against potential losses in a portfolio. They offer a way to profit from a decline in an asset's price with limited risk (the premium paid).
- Just like call options, put options provide leverage, which increases both potential gains and losses as compared to the amount of capital invested in the premium.
Key Components of Call Option and Put Option
Call Option and Put Option have the following components:
| Parameter |
Call Option |
Put Option |
| Underlying Asset |
The asset that the option gives the holder the right to buy. |
The asset that the option gives the holder the right to sell. |
| Strike Price |
Price at which holder can buy the underlying asset. |
Price at which holder can sell an asset. |
| Premium |
Price paid by buyer to the seller for call option. |
Price paid by a buyer to the seller for the put option. |
| Expiration Date |
The last date by which call option must be exercised or it expires worthless. |
The last date by which the option must be exercised or it expires worthless. |
FAQs
Can you lose money on call and put options?
Yes, the buyer of a call or put option can lose money. If the option expires as worthless (i.e., the asset price does not increase or decrease as expected), the buyer loses the entire premium paid for the option.
What does it mean to exercise an option?
To exercise an option means to use the right granted by the option contract to buy (in the case of a call option) or sell (in the case of a put option) the underlying asset at the strike price.
What are the risks of selling call and put options?
Selling or writing call and put options carries unlimited risk. If the market moves against the position, the seller may have to buy or sell the underlying asset at unfavorable prices, potentially leading to significant losses.
Can options be sold before expiration?
Yes, most options contracts can be sold before their expiration date. This allows the holder to realize a profit (or limit a loss) without having to exercise the option.
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