Options are a massive topic of interest in the trading world, more so in 2020 than ever, it would seem! There are two types of core options, puts vs calls. So what is the difference between put options and call options when trading this derivative market?
First to quickly summarize. An options contract is a right to buy or sell the underlying stock at a specified price at some point in the future. The options buyer has the right. The options seller has the obligation should the buyer of the option decide to exercise the position.
What is a Put option?
A put option is a contractual agreement between a buyer and a seller to allow the buyer (not obligation) to sell or short sell the underlying asset. The buyer locks in a price point (strike) and a point in the future which is predetermined.
Each option expires, that is why you choose a predetermined date in the future for when you decide to exercise the option of not. However, you do not have to wait until that expiry date to close out the options position. You can make a profit before the expiry date if the option has gained value.
On the other hand, the put seller is obligated to sell you the underlying security upon expiry if you choose to exercise your option.
Let’s look at the components of a put option:
- Strike: This is the price that you are expecting the underlying to reach by the expiry
- Bid: The highest price the buyer of the options is willing to pay for the option. (premium seller receives)
- Ask: The lowest price the seller is willing to receive for options price (premium paid by buyer)
- Difference between bid and ask: The spread, the difference is what the market maker receives
How to use Puts?
A put option is typically used by investors as a means to hedge their long positions. What that would mean is if you as an investor-owned 200 shares of Apple. You have had them for a while and are experiencing good gains! You want to protect those gains should the price drop so you are willing to buy insurance on the shares. The put option allows for the investor to gain on the value of the option as the price drops so it offsets the loss that would have been incurred from the downside in the stock.
Traders use put options for speculative reasons as well when an asset is dropping. Traders buy put options by paying a premium. When the asset falls, the put option gains value. So the premium that they paid is now worth more than when bought. Speculators can then sell that option on the secondary market for a profit.
On the other hand, the put sellers can be either hedgers or speculators as well. The put sellers that speculate would sell the option to generate the premium. This is a source of income that would go straight into the pocket of the put seller if the price of the asset went up.
- Put buyers profit from falling underlying asset prices
- Put sellers profit from rising underlying asset prices
Put Options Example and Risk
Using the example above. If Apple is $120 currently, and if you anticipate that the price of Apple will be at most $113 in 3-months by the time the options expire. So I would then, as a put buyer purchase Apple puts at 113 strikes for $4.95 at the Ask price. This is the premium paid however if you purchase 1 contract of Apple puts, there are 100 shares in each contract so you would pay $495 in premium for the 1 contract. If the price of Apple drops you will gain money on the premium you paid! You will gain on the position even if Apple does not drop under $113. HOWEVER! That is only if it drops before expiry, in the first month for instance. So if Apple starts at $120 and in a month’s time we have dropped to $116 you will see again in your options position. However, by the time the position expires you will need to see Apple under $113 minus the premium paid of $4.95. So your breakeven point is $107.05 upon expiry. The maximum loss is the price you pay for the premium. So in this case $495.
This is the profit and loss graph of a long put option (Image from project option).
On the other end, the short put is used as a passive income strategy. This is considered non-directional. If Apple is currently at $120, as long as you don’t anticipate the price of Apple dropping under $120 minus the premium received for that option you will collect the full premium. This is often done with strong equity positions so that you can generate the premium and gain unrealized profit from the long position.
What is a Call option?
A call option is a contractual agreement between a buyer and a seller to allow the buyer (not obligation) to buy the underlying asset. The buyer locks in a price point (strike) and a point in the future which is predetermined.
Each option expires, that is why you choose a predetermined date in the future for when you decide to exercise the option of not. However, you do not have to wait until that expiry date to close out the options position. You can make a profit before the expiry date if the option has gained value.
On the other hand, the call seller is obligated to sell you the underlying security upon expiry if you choose to exercise your option.
Let’s look at the components of a call option:
Just like the put options chain, the call options chain reflects the exact same aspects.
How to use Calls?
A call option is typically used by investors as a means to secure a buy price on an asset should that asset go up in value. If you anticipate that Apple shares will go up to $150 in 6 months, but you don’t want to buy 100 shares outright right now if they are at $115, but rather only $290 which is the June 2021 115 Strike premium for the option. If you pay $640 today, you can buy Apple shares at $115 in June if they are worth $150. If that is not the case, you lose the premium and it only cost you $640 for the opportunity. If Apple does hit $150. You have the chance of taking home:
- ($150-$115) x 100 =
- ($35) x 100 =
- $3,500
- $3,500- $640 (paid for the option) =
- $2,860 total gain.
You would need $11,500 in your account to purchase the shares of Apple in 6-months. However, that is a substantial return. You could also just turn around and sell the options at that time for a larger ROI.
Shares ROI:
- 2,860/11,500=
- 9%
Options ROI:
- 3,500/640=
- 88%
Traders often use call options for speculative reasons rather than planning to buy the shares of the stock into expiry. Someone would buy Apple call options in anticipation that the stock goes up and the premium gains value so you can sell it on the secondary market for a profit before expiry.
Even if you buy OTM Apple options for a later expiry and the price does not reach the strike by expiry but goes up in value you will still be able to make money from that options contract.
On the other hand, the call sellers can be either hedgers or speculators as well. The call sellers that speculate would sell the option to generate the premium. This is a source of income that would go straight into the pocket of the put seller if the price of the asset went down.
- Call buyers profit from rising underlying asset prices
- Call sellers profit from falling underlying asset prices
Call Options Examples and Risk.
Using the example of Apple again! If we see that AAPL is trading at $116.50 currently and we anticipate a move up to $130 in the coming month. We would want to purchase some call options to take advantage of this. Using the options chain below, we see we can purchase a 127 strike of Apple call options for Dec 31st expiry for $1.12 or $112 per contract. IF we want to purchase 100 shares at $127 we would need to see Apple above that price into the expiry. However, if we are only speculating that Apple will move a lot within the first 2 weeks of this 4 weeks expiry we can buy the cheaper OTM call strike which is at $127.
The profit and loss for a long call option area such. The max risk you incur is the total of the premium. The breakeven point is the strike of the call plus the cost of the premium. Assuming a call option strike at 100 costs $5.00. By expiry, the price will have to be at least $105 for you to make money. Now that break-even point is only considering expiring. If that option moves up well before the expiry but not to the strike you will still be a net positive. If the stock is currently at $80 and the strike is at 100 for a 3-month expiry. If the stock moves to $88 in the first 2 weeks you are making money. The profit is technically unlimited.
The short call however is a premium generator and is more of a bearish strategy. You would want to see the price fall or stay under a specific strike should you collect a premium from your short call option. The max reward of the short call is the premium received. The max risk is technically infinite as stock prices can rise infinitely.
Puts vs Calls?
So when to use puts and calls? When to use short puts and short calls? At TRADEPRO AcademyTM we understand one thing, that longer-term puts are very risk to buy as the market has a general long skew. Long term puts are to be bought on really weak companies. So that means generally if you are swing trading, look for stocks with strength, which for the majority of the time is a lot of names out there.
Traders should consider looking for long calls the majority of the time. The stock market spends a majority of its time in a bull trend. Just before the 2020 March financial crash, we were in an 11-year bull market, which burned a lot of puts.
Meaning there is a time and place to look for put options when we have those strong downside swings, however, they do not happen often, nor are there a lot of them.
In that case, you could be looking for short put strategies the majority of the time in the market. Which means that we should consider the short calls as well, considering the market generally likes the upside, short calls are to be used as insurance in combination with long calls to minimize the cost of the position on the long side.
There is a time and place for long calls and long puts. That is in the realm of day trading. Day traders see short fluctuations in market prices and they can either be to the upside or downside, so within a day you can be a buyer of puts. However, keep in mind that you should look to close that position out before the day ends because you can see a quick reversal of that and obliteration of your premium.
When to use calls:
- Long calls – when you are outright bullish on a stock
- Short calls- when you are almost certain that a stock will stay below a certain threshold price. Or when you are collecting premium against your long calls to balance out the premium paid.
When to use puts:
- Long puts – when you are outright bearish on a position. Keep in mind that you are risking a lot when you swing trade puts should the market conditions not be perfect.
- Short puts – when you are slightly bullish on a position. Collecting premium against you outright puts.
Take a look at NIO below. This chart is undeniable to the upside, so overall swing trading puts will get you burned. However, intraday you had the opportunity to look for put day trades. Keep in mind that you should close them out before the day ends. That is because the next, for the most part, that position gets completely reversed.
Conclusion:
Puts and calls are great derivative tools to use in the market on a daily basis and even further out if you are a swing trader. However, there are a lot of complexities in the options market that you should be aware of. The first step is understanding the basics outlined in this article. What are puts and calls? When should you use them and examples! Remember to manage risk.
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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 AcademyTM is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.
