Difference Between Call and Put Options: Explained with Meaning & Examples

Key Takeaways

• Call options provide the right to buy an asset. Traders buy call options when they anticipate a rise in the asset price.
  

• Put options offer the right to sell an asset. Traders buy them when they anticipate a decline in asset price.
  

• Call options are suitable for the bullish markets. However, put options are preferred in bearish markets.
  

• Profits from call options may be unlimited. However, you will get limited profits with put options.
  

• When call options are in-the-money, the strike price is lower than the spot price. However, the strike price is higher than its spot price when the call option is out-of-money. This is the opposite for the put options.
  

Options are impactful financial instruments that provide traders like you with the flexibility to profit from market movements, be it when prices are rising, falling or even staying flat. Unlike traditional stock investing, options offer strategic ways to manage risk, hedge portfolios or amplify potential returns. At the heart of options trading lie two core instruments: call options and put options. This article takes a closer look at what they are, how they work, and how they fit in a diversified investment portfolio.

What Is a Call Option?

With a call option, you have the right (but no obligation) to purchase a stock at a specific price (the strike price) before a specified expiration date. In simpler terms, a call option is a contract that allows traders to profit from a potential rise in the price of a stock without buying the stock outright. Traders usually buy call options when they expect the price of the underlying asset to increase. When the asset price goes above the strike, the holder can buy the asset at a low price. Thus, they acquire the asset at a price below the market price.

How to Calculate Call Option Payoffs?

Knowing how to calculate call option payoffs is essential if you are looking to navigate the options market with confidence. As mentioned earlier, a call option gives the buyer the right, but not the obligation, to purchase an underlying asset at a predetermined price before or on the expiry date. The payoff from a call option depends on the difference between the market price of the asset at expiry and the strike price, minus the premium paid. If the asset’s price rises above the strike price, the option becomes profitable; if it stays below, the maximum loss is limited to the premium. Accurately calculating this payoff helps you as a trader assess potential returns, manage risk and make informed decisions in volatile markets.

What Is a Put Option?

With a put option you have the right, without any obligation, to sell a particular asset, frequently a stock, at a predetermined strike price before a specified expiration date. In the stock market, a put option protects against falling prices or allows you to profit from a declining stock without short selling it directly. Essentially, put options provide investors like you with a strategic advantage, enabling them to profit from a potential decline in the stock's market price. When the market price falls below the strike price, the holder can sell the asset at the higher strike price, thereby realising a gain.

How to Calculate Put Option Payoffs?

Calculating the payoff of a put option is an important step in understanding how this powerful derivative can work for you. A put option, as previously mentioned, gives the buyer the right, but not the obligation, to sell an underlying asset at a specified strike price before or on the option’s expiry. The payoff from a put option is determined by how far the market price falls below the strike price, which means the greater the drop, the higher the profit. If the asset’s market price stays above the strike price, the put expires worthless, and the loss is limited to the premium paid. By knowing how to calculate the payoff, as a trader, you can effectively evaluate downside protection strategies or profit from anticipated price declines.

Important Terms Related to Call and Put Options

• Strike Price or Exercise Price: The fixed price at which the asset can be bought (call) or sold (put) when the option is exercised.
  
• Premium: The amount paid by the buyer to purchase the option. It’s non-refundable and represents the maximum loss of the buyer.
  
• Expiry Date: The final date till which the option contract remains valid is called the expiry date. After expiry, the option ceases to exist.
  
• At the Money (ATM): When the market price of the asset is equal to or nearly equal to the strike price.
  
• Intrinsic Value: The value an option holds if exercised now:
  Call: Market Price – Strike Price
  Put: Strike Price – Market Price
  
• Time Value: The portion of the premium based on the remaining time until expiry and market volatility.
  

Note: Intrinsic value can never be negative. It is always zero or positive. Out-of-the-money options have zero intrinsic value, and their entire premium consists of time value.

What Happens to Call Options on Expiry?

In-the-Money (ITM) Call Options: If a call option expires in the money, it is generally exercised automatically by the exchange. The holder receives the intrinsic value minus any applicable charges.

Out-of-the-Money (OTM) and At-the-Money Call Options: If a call option expires out of the money or at the money, it expires worthless. The holder, thus, loses the premium paid for the option, but there are no further obligations or losses beyond this amount. The contract just lapses from the account after expiry.

What Happens to Put Options on Expiry?

Physical Settlement for Stock Options: If a stock put option expires in the money, it is subject to physical settlement. Thus, the option holder must deliver (sell) the underlying shares at the strike price to the option writer, or if they don’t own the shares, they must acquire them to settle the contract.

If the put option is out of the money or at the money, it expires worthless, and no action is required. The premium paid is lost and no further obligation exists.

Cash Settlement for Index Options: For index put options, expiry is settled in cash. If the put expires in the money, the profit is paid as the difference between the strike price and the index’s closing price on expiry day, minus the premium paid.

If the index put is out of the money or at the money, it expires worthless, and the premium is lost.

Note: Since 2019, all stock options are physically settled. Index options remain cash-settled

Conclusion

Call option and put option hold a place of significance in investors’ toolkit, allowing for a nuanced approach to market dynamics. Mastering these essential derivatives equips individuals like you with the flexibility to adapt to changing circumstances, ensuring they can navigate the financial landscape with confidence and agility.