Basics of Put and Call Options
The power of options lies in their versatility. They can be used to speculate market moves or to protect a position. In this lesson, we will focus on how a speculator can make use of easyMarkets vanilla options.
The two types of options are Puts and Calls:
- A Put gives the holder the right, but not the obligation, to sell at an agreed upon price on expiry.
- A Call gives the holder the right, but not the obligation, to buy at an agreed upon price on expiry.
The agreed sell/buy price available to an option holder is called the strike rate. An option buyer will benefit if the strike rate can beat the market! If you are holding a Call option, the strike will become more attractive as the market rises, and if you are holding a Put option, the strike will become more attractive as the market falls. Here’s an example:
Buy Put example
If company ABCD is trading for $50/share and you expect the share price to fall, but you don’t have the confidence to short (through selling) the stock because there is a possibility you could face an unlimited amount of loss if you are wrong, you can buy a Put option instead, giving you the right to sell at a specified price any time before the expiration date.
You choose to buy a Put option giving you the right to sell the stock at $40 over the next month. This option will cost you $5.
- Strike – $40
- Expiry date – 1 month from today
- Premium to pay – $5
Now, imagine the scenario in which the company’s share price does what you expect. It goes down, and before the end of one month, it has gone down to $20. Then, you decide to exercise your option, which allows you to sell the stock at $40. If you don’t own it, that’s ok because you can go and buy the stock right now on the market at $20. You are buying at $20 and selling at $40, thus you are making $20. The graph below shows how this would look.
Then, if you subtract the premium you paid for the option you will have a $15 profit.
On the other hand, if your bet goes against you and the share price goes up, it’s not like a short (selling) position where you can lose an unlimited amount of money. The maximum risk when you buy an option is the premium paid, in this case that is $5. Even if the stock went to a trillion dollars, you are not required to buy it back like you would if you were shorting it. For an example of how a short position would look, see graph below.
Under the same reasoning, you can buy a Call option to trade a rising share price. If the price rises the Call option allows you to buy at a lower price than the market. The difference between your Call option’s strike rate and the market rate is your profit (before subtracting the premium paid for the option).