What Is A Call Option?
A call option is a contract that gives the buyer the right, but not the obligation, to buy 100 shares of a stock at a specified price for a certain amount of time.
When you are bullish on a stock and want to put on a position that benefits from a rise in the stock price, you could buy a call option. That option allows you to control the price of a stock for a specified amount of time and will also allow you to benefit from a move higher in the price of the stock for a fraction of the cost.
As long as the stock goes up, the call option owner has unlimited profit potential with limited risk.
The downside to owning a call option is that the stock needs to move in your direction before the option expires, otherwise you will lose your investment.
A seller of a call option is required to sell the shares of stock to the option buyer at an agreed upon price should the buyer decide to execute their option.
The seller is obligated to deliver the shares to the buyer should they ask for them, but in return they collect a premium from the option buyer.
The seller is very similar to the insurance company. If the stock doesn’t go up, then the seller gets to keep the premium as profit.
What Is A Put Option?
A put option is a contract that gives the buyer the right, but not obligation, to sell 100 shares of a stock at a specified price for a certain amount of time.
When a trader is bearish on a stock and wants to profit from the stock moving lower, they can buy a put option that will increase in value as that stock moves lower. As long as the stock goes lower the put option owner has unlimited profit potential with limited risk.
A put option locks in the selling price for a specified period of time.
The downside to owning a put option is that the stock needs to move in your direction before the option expires otherwise the trader will lose their investment.
A put option can also be used to hedge an existing stock position by locking in a sales price going forward.
Let’s say a trader has owned shares of stock for an extended period of time and wants to protect some of the gains that they have. The trader could purchase a put option that will lock in a sales price for the stock which gives them the right to sell their shares of stock at a given price for a set amount of time.
If during that time the stock crashes the put option owner has the right to sell their shares at the strike price of the option.
The put seller has the obligation to buy the shares of stock should the option owner decide to exercise their right to sell their shares of stock.
In return the seller of the put option collects a premium just like an insurance company would. If the owner doesn’t exercise their option then the seller gets to keep the premium collected as profit.
Put vs. Call: Which option is best?
While there are a number of different ways to play these setups, we will often time look to use the front month options.
We also like to buy low volatility and sell high volatility.
This means we could use different options trading strategies such as:
- naked calls and puts
- iron condors
- vertical spreads
We will select the correct strategy based on criteria such as overall market conditions, anticipated holding time and levels of implied volatility being priced into the options.