Market Basics: Put Options & Call Options

What is an option?

The simplest explanation of an option is a contract which allows a certain party (the option holder) to execute a transaction and buy a stock, bond, commodity or other instrument from a second party (the option writer/issuer) at a specified price before a specified date. The contract gives the option holder the power to execute the trade, but he or she is not contractually obliged to do so. In other words, to the holder an option is a right, not an obligation.

Options are a certain form of derivative[1] related to an underlying asset. This can be any type of asset or commodity. For instance, one can find stock options as well as gold options. Making returns would be fairly simple if options were free, due to the lack of obligation. The investor could simply decide to purchase the asset if it had risen above the specified price or, conversely not pursue the purchase if the asset had under performed. However, as there is no ‘free lunch’ in finance, options are sold at a premium price, higher than the regular market price of the underlying asset.

What are the differences between put options and call options?

A put option stating a given strike price (the aforementioned specified price on the contract) gives the holder the right to sell the asset for that stated price within the given period. From the other end of the spectrum, the writer or issuer (the party that agreed on the contract with the holder) has a contractual obligation to buy the asset at the strike price if the holder decides to proceed with the sale. A further remark about options to be made is that they have a certain expiry date. This means that the holder can make use of the contract only as long as the option is valid.

Call options give the holder of the option the contractual right to buy the asset at a specified strike price as long as the option is valid. Contrarily to the put option, the writer or issuer has the legal obligation to sell the asset to the holder, rather than buy it from him or her. Intuitively, a call option loses its value if the market price does not reach the price written on the contract, as the holder will not proceed with the purchase, but still incur the costs of the contract.

When are put/call options used?

Exercising a call option only adds value when the market price of the underlying asset exceeds the strike price on the contract before the expiry date. The investor will then be able to purchase it for a price below the one of the market, utilizing his legal rights.

Call options are used when the investor is bullish on the asset, or in other words when he or she anticipates an upward price movement. Meanwhile, put options become profitable when prices drop. The holder has the right to sell the asset at the strike price and his return will be the margin between the superior strike price and the lower market price.

We hope you enjoyed the third part of the Market Basics series. Feel free to leave any feedback or thoughts in the comments below!

[1] A derivative is a financial security with a value that is reliant upon or derived from an underlying asset or group of assets. Read more about derivatives at https://www.investopedia.com/terms/d/derivative.asp#ixzz5SyG8ehX7