Options are a contract between a buyer, who is known as the option holder, and a seller, who is the option writer.
This contract gives the holder the right, but not the obligation, to buy or sell an underlying security at a specific price, known as the strike price, by an expiration date.
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There are two types of options: calls and puts.
Call options and put options are different, but both offer the opportunity to diversify a portfolio and earn another stream of income. However, there is risk involved in options trading. It is imperative to understand the difference between call options and put options to limit that risk.
This article will explain key differences and better prepare investors to profit from call and put options.
Call options give the holder the right to buy shares of the underlying security at the strike price by the expiration date.
If the holder exercises his right and buys the shares of the underlying security, then the writer of the call option is obligated to sell him those shares. If the holder does not exercise his right before the expiration date, then the option expires and becomes worthless.
The holder of a call option pays a premium to the writer of the option. Before buying the call option, the holder should expect the market value of the underlying security to rise, in contrast to the option writer who will profit if the security dips in value.
Let’s look at an example to see how to profit from either holding or writing a call option.
Call Option Example:
Imagine that shares of General Electric Company (NYSE: GE) are trading at $13 each.
A call option could be purchased by an investor who expects the market value of GE to rise. Suppose the strike price of that call option is $15 and the expiration date is in one month.
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The purchaser of the call option pays a premium to the option writer of $1 per share, or a total of $100, because one option contract equals 100 shares of the underlying stock. If the price of GE stock rises beyond $15 to $18, the call option holder can exercise his right to buy 100 shares of GE at $15. The option writer sells the shares to the call option holder at that price.
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The option holder who chooses to receive the 100 shares at $15 then immediately sell those shares at the market price of $18. This exchange produces $3 per share, or $300, for the option holder.
After subtracting the $100 paid as a premium for the call option, the option holder can keep a profit of $200.
Buying a put option
If the GE stock did not go above the strike price of $15 within the month before the expiration date, then the call option would expire worthless. If that occurs, the writer of the option would retain a profit of $100.
Put options give the holder the right to sell shares of the underlying security at the strike price by the expiration date.
If the holder exercises his right and sells the shares of the underlying security, then the writer of the put option is obligated to buy the shares from him. Similar to a call option, if a put option holder does not exercise his right before the expiration date, then the option expires worthless.
To acquire a put option, a premium is paid by the holder to the writer.
A put option holder expects the market value of the underlying security to fall, whereas the writer is betting the security will increase.
Let’s look at an example to see how to profit from either holding or writing a put option.
Put Option Example:
If Ford Motor Company (NYSE: F) shares are trading at $11 each, an investor who expects the stock price to drop can buy a put option in an attempt to profit.
Suppose the strike price of the put option is $9 and the expiration date is in three weeks. The option buyer can pay a premium to the option writer of $1 per share, or $100.
If the price of Ford stock goes down to $7 within those three weeks, the option holder can exercise his right on the put option and buy the Ford shares at $7, then sell them at $9 each.
The option writer is obligated to buy them from option holder for $9 each. This generates a profit of $2 per share, or $200, for the option holder.
After paying the premium, the option holder keeps a profit of $100. If the Ford stock did not go below $9 within the three weeks, then the put option would expire worthless.
The writer of the option would then retain a profit of $100.
This article clarifies key differences between call and put options. Investors now should be better prepared and more confident when trading options.