Call option and Put option are the two main types of options available in the derivatives market. A Call option is used when you expect the prices to increase/rise. A Put option is used when you expect the prices to decrease/fall. Warren Buffett has described derivatives as weapons of mass destruction. Options, a type of derivatives, also falls under the category of weapons of mass destruction. But what if we told you that if used correctly, these weapons of mass destruction can become the tools for building infinite wealth and hedging portfolio risks? Sounds interesting right? But to create wealth using options, we first need to learn the basics of options. In this article, we will discuss the basics of options including what are call options, what are put options, call and put options examples and also simplify puts and calls for beginners. Let’s begin. What are Options? - Definition of Options
Options are derivative contracts which have no value of their own and derive their value from the value of the underlying asset. The underlying asset can be shares, currencies, commodities etc. An options contract gives the buyer the right but not the obligation to buy or sell the underlying asset within a specified date (known as the expiration date) and at a specific price (known as the strike price). In options, the buyer of the option has the right of exercising the option or cancelling it. The loss for the option buyer is limited to the premium paid. For example, curd is a type of derivative as it has no value of its own. It derives its value from the value of the underlying asset i.e. milk. If you expect the price of milk to increase, then the price of curd will also automatically increase. To benefit from this, you can buy a call option of curd, as you expect the prices to rise.Types of Options in India
The two main types of options are:- Call Option
- Put Option
What is a Call Option?
A call option gives the buyer the right but not the obligation to buy the underlying asset at a particular price (strike price) on or before the expiration date.Watch our Detailed Video on Call Options Trading for Beginners
https://youtu.be/720RP-zaH5kWhat is a Put Option?
A put option gives the buyer the right but not the obligation to sell the underlying asset at a particular price (strike price) on or before the expiration date.Watch our Detailed Video on Put Options for Beginners
https://youtu.be/GXZS0sBqhowCall and Put Options for Beginners
| Price of the underlying asset | What to do |
| Expected to increase | BUY Call Option or SELL Put Option |
| Expected to decrease | BUY Put Option or SELL Call Option |
Basic terms relating to call and put options:
- Strike Price: Strike price is the price at which buyers and sellers decide to buy or sell the underlying asset after a specified period.
- Spot Price: Spot price is the current price of the underlying asset in the stock market.
- Option Expiry: Options contracts expire on the last Thursday of the month.
- Option Premium: Option premium is the non-refundable amount paid upfront by the option buyer to the option seller (also known as option writer).
- Settlement: Option contracts are cash settled in India.
Call Option Example:
In the below screenshot, the current price of Reliance Industries on 7th December 2020 is Rs 1,953.15 and its Rs 2,000 call option expiring on 31st December 2020 is currently available at Rs 57.15. 1 lot of Reliance option contract is 505 shares.
So, in the above call option example: Spot price - Rs 1,953.15Strike price - Rs 2,000Option premium - Rs 57.15Expiry - 31st December 2020Lot Size - 505 sharesWhen to buy the call option: If you expect the price of Reliance Industries to increase to Rs 2,000. When to exercise the call option: Once the share price of Reliance Industries rises to Rs 2,000 you have the option to exercise the call option and the seller is obligated to sell you 1 lot of reliance industries at Rs 2,000/share as you have paid him a premium of Rs 57.15, which binds him to the contract. When to cancel the call option: On the other hand, if Reliance industries does not cross Rs 2,000 before 31st December 2020, then you can cancel the contract. Your loss in that case is the Rs 57.15 paid as premium to the option writer. The reason for cancelling the contract is simple: Why will you buy Reliance shares at Rs 2,000 from the seller if you can buy it at a cheaper rate from the stock market? Hence you cancel the contract. Put Option Example:
So, in the above put option example: Spot price - Rs 1,953.15Strike price - Rs 1,900Option premium - Rs 46.30Expiry - 31st December 2020Lot Size - 505 sharesWhat is the Difference Between Call Option & Put Option?
| Parameters | Call Option | Put Option |
| Meaning | Call option gives the buyer the right but not the obligation to Buy | Put option gives the buyer the right but not the obligation to sell |
| Investor’s expectation | A call option buyer believes the stock prices will rise / increase | A put option buyer believes the stock prices will fall / decrease |
| Gains | For a call option buyer, the gains are unlimited. | For a put option buyer, the gains are limited as the stock prices will not become zero. |
| Loss | For a call option buyer, the loss is limited to the premium paid. | For a put option seller, maximum loss is strike price minus premium |
| Reaction to dividend | Calls lose value as the dividend date nears. | Puts increase in value close to the dividend dates. |
What Happens to Call Options on Expiry? - Buying Call Option
When you buy a call option, three things can happen on expiry:- Market Price > Strike Price = In the Money call option = Gains / Profits
- Market Price < Strike Price = Out of Money call option = Loss
- Market Price = Strike Price = At the Money call option = Break - Even (No profit no loss)
What Happens to Call Options on Expiry? - Selling Call Option
When you sell a call option, three things can happen on expiry:- Market Price > Strike Price = In the Money call option = Loss
- Market Price < Strike Price = Out of Money call option = Gains / Profits
- Market Price = Strike Price = At the Money call option = Profit in the form of premium.
What Happens to Put Options on Expiry? - Buying Put Option
When you buy a put option, three things can happen on expiry:- Market Price > Strike Price = Out of Money put option = Loss
- Market Price < Strike Price = In the Money put option = Gain / Profits
- Market Price = Strike Price = At the Money call option = Loss of premium paid.
What Happens to Put Options on Expiry? - Selling Put Option
When you sell a put option, three things can happen on expiry:- Market Price > Strike Price = Out of Money put option = Gains / Profits
- Market Price < Strike Price = In the Money put option = Loss
- Market Price = Strike Price = At the Money call option = Profit in the form of premium.
Risk vs Reward - Call Option and Put Option
| Call Buyer | Call Seller | Put Buyer | Put Seller | |
| Maximum Profit | Unlimited | Premium received | Strike price minus premium | Premium received |
| Maximum Loss | Premium Paid | Unlimited | Premium paid | Strike price - premium |
| No Profit - No loss | Strike price + premium | Strike price + premium | Strike price - premium | Strike price - premium |
| Ideal Action | Exercise | Expire | Exercise | Expire |
Very well explained, simple and easy.
Thank you very much for the feedback!
What is it called when you bet the stock to go down?
Don’t you make 3x your money or more when the stock goes down?
Looking to understand
Love the explanation!!!
Made it so understandable. Thanks.
Very simple with a good example explained easily to understand. Thanks
Very well explained, with best example.