What are call and put options?

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Now that you know what options are and how they differ from futures, let’s get to know the basics of call and put options and try to understand their process flow. Basically, you know that there are call options and put options. You can buy one of each and attempt to minimize your losses if you’re unsure of where the market is heading in the near future. Or, if you have a fairly certain assumption about future market trends, you can buy a call option or a put option, depending on the market movement. 

Understanding the basics of call and put options and learning how work can be useful for traders who’re new to the derivative market, so they can formulate appropriate options trading strategies. Let’s get into the details.  

Call option: An example

A call option gives the buyer of the option the right to buy an asset. On the other hand, the seller of the option has no such right, and is mandated by the option contract to sell the asset to the buyer (if the buyer exercises his right to purchase). 

In exchange for effectively giving up his rights, the seller of the option charges a certain amount from the option buyer, termed as the ‘premium.’ Consider this ‘premium’ amount as a kind of a security deposit charged by the option seller to indemnify himself in the event of the buyer not exercising his option. 

Let’s take a look at an example to better understand the concept of call options.

Assume that Ambuja Cements is trading at Rs. 200 today. In the near future, say one month down the line, you expect the price of this stock to rise. So, you wish to lock in the current price today, so you can buy at this low price in the future. 

However, you’re also cautious by nature, so you want to account for the alternative outcome too - what if the prices fall instead? So, basically, you want the choice (and not the obligation) to buy the share at Rs. 200 in the future.

Here’s where an options contract can help. And this kind of an options contract - one that gives you the right to buy an asset at a predetermined price, on a future date - is known as a call option.

Meanwhile Ram, another trader, is 100% certain that the price of Ambuja Cements shares will fall in the near future. In other words, he’s keen on entering into a contract that will help him sell the share one month later at Rs. 200, since he believes the prices at that time will be much lower.

So, the two of you enter into a contract. You buy a call option from Ram. In other words, you buy the right to purchase the share of Ambuja Cements from him at Rs. 200 one month from now. By that point, you expect the price to be higher than Rs. 200. Ram, meanwhile, sells you that right to purchase the share of Ambuja Cements at Rs. 200.

This price (Rs. 200) is known as the strike price of the option.

Here, you’re the buyer of the options contract and the purchaser of the asset. And Ram is the seller of the options contract and the seller of the asset.

As a result of selling you the right to purchase the share, Ram is effectively obligating himself to sell you the shares in the process. And, as a compensation for any loss that he might incur if you decide to not exercise your option, Ram charges you a premium amount of say Rs. 20.  

  • At the end of one month, if the price is higher than Rs. 200 (say Rs. 250), you will exercise your right to buy the share for a lower price - in this case Rs. 200.
  • But at the end of one month, if the price is lower than Rs. 200 (say Rs. 180), you will not exercise your right to buy the share for a higher price - in this case Rs. 200. 
  • However, since you’ve not exercised your option, Ram gets to keep the premium that you paid to enter into the contract as compensation.  
  • Whatever you decide, Ram, being the seller of the contract, is obligated to follow through and act accordingly.

Put option: An example

So, what is a put option? Unlike a call option, a put option gives the buyer of the option the right to sell an asset. On the other hand, the seller of the option has no such right and is mandated by the option contract to buy the asset if the other person decides to exercise their right to sell. 

In exchange for effectively giving up his rights, the seller of the option charges a certain amount from the option buyer, termed as the ‘premium.’ Again, consider this ‘premium’ amount as a kind of a security deposit charged by the option seller to indemnify himself in the event of the buyer not exercising his option. 

Let’s take up the example of Ambuja Cements once again to try to understand put options. 

Once again assume that Ambuja Cements is trading at Rs. 200 today. In the near future, say one month down the line, you expect the price of this stock to fall. So, you wish to lock in the current price today, so you can sell at this high price in the future.

However, again, being cautious by nature, you want to account for the alternative outcome as well - what if the prices rise instead? So, basically, you want the choice (and not the obligation) to sell the share at Rs. 200 in the future.

Again, an options contract can be helpful here. And this kind of an options contract - one that gives you the right to sell an asset at a predetermined price, on a future date, is known as a put option.

Meanwhile Ram, another trader, is 100% certain that the price of Ambuja Cements shares will rise in the near future. In other words, he’s keen on entering into a contract that will help him buy the share one month later at Rs. 200, since he believes the prices at that time will be much higher.

So, the two of you enter into a contract. You buy a put option from Ram. In other words, you buy the right to sell the share of Ambuja Cements to him at Rs. 200 one month from now. By that point, you expect the price to be lower than Rs. 200. Ram, meanwhile, sells you that right to sell the share of Ambuja Cements at Rs. 200.

Here, you’re the buyer of the options contract and the seller of the asset. And Ram is the seller of the options contract and the buyer of the asset.

As a result of selling you the right to sell the share, Ram is effectively obligating himself to buy the shares from you in the process. And, as a compensation for any loss that he might incur if you decide to not exercise your option, Ram charges you a premium amount of say Rs. 20.  

  • At the end of one month, if the price is lower than Rs. 200 (say Rs. 180), you will exercise your right to sell the share for a higher price - in this case Rs. 200.
  • But at the end of one month, if the price is higher than Rs. 200 (say Rs. 250), you will not exercise your right to sell the share for a lower price - in this case Rs. 200.
  • However, since you’ve not exercised your option, Ram gets to keep the premium that you paid to enter into the contract as compensation.  
  • Whatever you decide, Ram, being the seller of the contract, is obligated to follow through and act accordingly.

Wrapping up

With this, we’ve come to the end of this chapter on the basics of call and put options. The concept of futures, call options, and put options don’t seem so complex or confusing now, does it? In the next couple of chapters, we’ll take up a call option and a put option and focus on calculating the payoffs that you’re likely to receive by trading it in the stock exchange. Till then, stay tuned!

A quick recap 

  • Understanding how call and put options work can be useful for traders who’re new to the derivative market, so they can formulate appropriate options trading strategies.
  • A call option gives the buyer of the option the right to buy an asset. 
  • On the other hand, the seller of the option has no such right, and is mandated by the option contract to sell the asset to the buyer (if the buyer exercises his right to purchase). 
  • In exchange for effectively giving up his rights, the seller of the option charges a certain amount from the option buyer, termed as the ‘premium.’
  • Unlike a call option, a put option gives the buyer of the option the right to sell an asset. 
  • On the other hand, the seller of the option has no such right and is mandated by the option contract to buy the asset if the other person decides to exercise their right to sell. 
  • In exchange for effectively giving up his rights, the seller of the option again charges a certain amount from the option buyer, termed as the ‘premium.’
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