The Ultimate Guide to Options : Call and Put Options

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06/12/2018 | 04:50 pm
Welcome back to the second part of our option series. In today’s chapter, we’ll take a closer look at the two types of options: call and put options. We’ll dive deeper into the functioning of both kinds of options and use examples to further illustrate things.



2. Call and Put options

2.1. Call options

Let’s start by taking a quick look at the definition of a call option we gave in the previous chapter again:

A call option gives you the right (not the obligation) to buy the underlying value at a predefined price, within or at a predefined date.

As we’ve seen in the previous chapter, each option has an underlying asset, an exercise - or strike - price, and an expiration date.

There are however a couple of other terms you need to know when it comes to options. Perhaps you’ve heard about an ‘in the money’, an ‘at the money’, or an ‘out of the money’ option before. These terms are related to the state that the option is in.

Let me explain.

Graphically speaking, this is how the payoff situation of a call option is presented:

Image source: The Options Guide
 

So, what do we see?

First of all, we notice that we start below zero. This makes sense since we had to pay an option premium. As soon as the share price hits the strike price of the option, the line starts going up. From the moment that happens, we say that the call option is ‘in the money’

In other words: A call option is in the money when the price of the underlying asset exceeds the strike price of the option.

As you can see, the fact that the call option is in the money doesn’t immediately mean that it is profitable too.

When a call option is at the money, the price of the underlying asset is at the same level as the strike price of the option.

Finally, we say that a call option is out of the money when - you may have guessed it already - the price of the underlying asset is below the strike price of the option.


2.2. When do you buy a call option?

There are various scenarios for people to buy a call option. For now, we’ll stick with a more basic example, however.

One of the more classic situations in which you could buy a call option is the following:

It’s the middle of the earnings season and a company you’ve been following for a while is publishing its quarterly results in a few days time. Let’s call the company Pear Ltd.

You expect Pear’s results to be better than analysts expect and you think the share price will go up quickly once the earnings are out. You want to benefit from this potential rise and decide to buy a call option.

Let’s say the share price of Pear is $50 in March. As we said, you expect good results in April which is why you buy a call option with a strike of $50 that expires in April. This option costs $2.

Two situations are possible here:

I. The share price goes up, as you expected. Pear’s results are good indeed and the share jumps up to $60.


 
This means that you can now buy the underlying share for $50. As such you end up earning 60 - 50 - 2 (the price you paid for the option) = $8. In other words, you earn less than you would have if you’d bought the share. But your risk was smaller too.

II. The share price tumbles. Pear’s results are not as good as you expected and the share price goes down to $40.


 
Since you bought an option you don’t have the obligation to buy the share. In this case, the option will be worth zero and the contract will expire. The maximum amount you can lose in this scenario is the price you paid for the option which is $2. If you’d bought the share you would have lost $10.
 

2.3 Put options

A put option is the exact opposite of a call option. Again, let’s start with the definition of a put option that we used before:

A put option gives you the right - not the obligation - to sell the underlying value at a predefined price, within or at a predefined date.

Graphically speaking, the pay-off situation of a put option looks like this:

Image source: The Options Guide


As you can see, this is exactly the opposite of the call option.

As soon as the share price goes below the strike price of the option, the line starts going up. From the moment that happens, we say that the put option is ‘in the money’

In other words: A put option is in the money when the price of the underlying asset falls below the strike price of the option.

As you can see, the fact that the put option is in the money doesn’t immediately mean that it is profitable too.

When a put option is at the money, the price of the underlying asset is at the same level as the strike price of the option.

Finally, we say that a put option is out of the money when - you may have guessed it already - the price of the underlying asset is higher than the strike price of the option.


2.4. When do you buy a put option?

Just like there are various scenarios for people to buy a call option there are various scenarios for people to buy a put option too. Again, we’ll stick with a more basic example for now.

One of the more classic situations in which you could buy a put option is the following:

It’s the middle of the earnings season and a company you’ve been following for a while is publishing its quarterly results in a few days time. Let’s call the company Kiwi Ltd.

You expect Kiwi’s results to be worse than analysts project and you think the share price will go down quickly once the earnings are out. You want to benefit from this potential drop and decide to buy a put option.

Let’s say the share price of Kiwi is $50 in March. As we said, you expect bad results in April which is why you buy a put option with a strike of $50 that expires in April. This option costs $2.

Two situations are possible here:

I. The share price goes down, as you expected. Kiwi’s results are bad indeed and the share falls to $40.



This means that you can sell the underlying share for $50. As such you end up earning 50 - 40 - 2 (the price you paid for the option) = $8. In other words, you earn money instead of losing some if you’d bought the underlying share directly.

II. The share price rises. Kiwi’s results are better than you expected and the share price goes up to $60.



Since you bought an option you don’t have the obligation to sell the share. In this case, the option will be worth zero and the contract will expire. The maximum amount you can lose in this scenario is the price you paid for the option which is $2. 


Before you go

Voila, the second chapter of our Ultimate Guide to Options is all done. In the next chapter, we’ll dive deeper into the intrinsic value of an option. Of course, there will be plenty of examples to illustrate things further. Until then, happy learning.

Neelie Verlinden
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