Options trading and use may seem difficult to most. The key to understanding all options theory and trading is to begin with the fundamentals. One must know what a call option is and what a put option is. These two options create the basis of all options trading strategies and combinations. Let’s talk about the call option vs put option definitions.
What is a call option?
The call option is a financial contract between two parties. The buyer and the seller. This is the most basic strategy that easily resonates with everyone. Its important to differentiate between options when talking about call option vs put option. The long call requires a market participant to buy a call option for a premium. A call option is a financial contract between two parties. The buyer of the option has the OPTION, not the obligation to buy the underlying stock upon the expiry of the option. The long call option strategy involves buying the call at a price point with a strike price (usually different from the price level). A trader speculates that the price of the market will surpass their strike price and maybe expire above that strike for a financial gain.
The short call option strategy is slightly different! It again involves a call option. Instead of buying it. A market participant sells the call option. The difference between the long call and the short call are simple. Instead of paying a premium for the call option like you do in a long call. You collect premium during a short call strategy.
How to use a call option?
A call option can be either used to the long side or the short side. There are many ways investors and traders alike use the call option. There are speculative reasons and hedging reasons. It can also be used in different options strategies to create options combinations.
Using the long call option.
The long call option resonates with people well and easily because it is essentially buying a stock, with a different financial instrument. As markets move up, your options gains value. This strategy is used often when a market participant wants to lock in a buying price for a stocK. Even if the stock moves without them to the upside they have the option to buy that stock at a lower level.
For example, if you did your analysis on Apple. You concluded that Apple would be trading at $280 per share in three months time. The current price is $210. You can buy a $215 strike call option. When Apple trades at $275-280 per share in three months you can then either take the gains from the options value or buy Apple at $215. As per the strike price. The risk of this strategy is limited to the premium you paid.
Using the short call option.
In the short call option trade, you collect is a limited gain. In this case you want to see the price of a stock fall so you can keep all the premium. The premium you collect is your maximum gain in this position. This is used a lot in conjunction with long stock positions or in bear markets. The short call options strategy alone is dangerous because the upside is unlimited. This is used typically if a trader or investor already owns the stock and they want to generate passive income from it. They can short as many contracts as they have shares and collect the premium while holding the stock. A different way to create your own dividend.
For example, again if Apple is holding resistance at $222 and you expect it go lower. You can gain premium of a short call option at $222 with the idea that Apple slips. If the call is worth $1.40/contract. Then you will receive $140 per contract since there are 100 shares per options contract. This strategy is more widely used if you are already long shares of the stock. So, it is not a naked short call. A naked short call is unprotected, and losses are unlimited. Theoretically the stock can go up forever. If you are long 200 Apple shares, and you are nervous that there could be downside in the stock. You can sell 2 options contracts to cover the position. You collect premium for those options as price drops so your losses on the downside of the stock itself are capped.
What is a put option?
The put option is another financial contract between two parties. Again, both a buyer and a seller. This is another basic options trading strategy that encompasses the simple buying of a contract. This time through you pay a premium for a put option in which you expect the price of the underlying to fall. A put option is an options contract that allows the owner of the put the OPTION and not the obligation to sell several stock shares at the put strike price.
A short put option strategy is very similar to that of a short call options strategy. The only difference is the direction. A short put options means that you are selling the put option to collect a premium. This means that you want the underlying stock to move in value, so you collect the full premium of the short put option.
How to use a put option?
The use of the put option is barely different than the use of the call option. We can therefore easily compare the call option vs put option. The put option has a long and short side, a buyer and a seller. It is used for hedging and speculation just like the call option. It can also be used in different options strategies to create options combinations.
Using the long put option.
This options strategy is useful for market participants that speculate that the price of a stock is going down. The max risk is limited to the premium paid for the option. This is often used instead of shorting a stock in many instances. This is because shorting a stock requires a lot of margin and the risk is technically unlimited. A stock can sore forever to the upside. Another way to use this options strategy is long stock protection. If you are long a number of shares in a stock and you expect prices to drop you can purchase a put that locks in a selling price for those shares.
An example of the long put is if you have downside interest in Apple. Say you think that the downside will open up and price will fall from the current $220 down to $190. If you do not have enough money to margin a short stock position or don’t want to take the risk, you can buy puts. If you have 200 shares of Apple stock that you bought at $180 months ago and price is now at $220. You feel that the price will drop to $170 if you do not want to take a loss on this position you can buy 2 put contracts. With a strike of $210-$200 to lock in a selling price at that level. So even if price drops to $170 and you are still holding onto the shares you have the option to sell them at $220 as per your strike.
Using the short put option.
The short put is a risky strategy because you are left unprotected should the price of the option fall. The risk is now limited by the stock only being able to drop to $0/share. However, that too comes with significant risk. This options strategy is used in conjunction with other options usually. Or in a bull market when you sell premium as stocks rally.
Main similarities: Call option vs Put option.
- Both options have a short and long side
- Both options require a buyer and a seller
- The long side for both requires premium to purchase
- The short side for both lets the seller collect premium
- The two are interchangeable
- They offer speculative profits
- They offer hedging components
- They both can hold unlimited risk
- They can both be used for options trading strategies
- They are the base for all options trading
Main differences: Call option vs Put option.
- A long call option requires price of the underlying to go up for profit
- A long put option requires price of the underlying to go down for profit
- A short call holds unlimited risk.
- A short put holds risk until the stock reaches $0.
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.