Call vs. put options: Understanding the differences
Editorial staff, J.P. Morgan Wealth Management
- A put option gives the buyer the right, but not the obligation, to sell an asset at a specified price (the strike price) before the option’s expiration date.
- A call option gives the buyer the right, but not the obligation, to buy an asset at a specified price (the strike price) prior to its expiration date.
- Buyers of put options make money on the difference between the strike price minus the premium the buyer must pay to buy the option and the lower price of the asset. The maximum loss is the premium paid to buy it.
- Buyers of call options make money on the difference between the strike price minus the premium paid and however much the price of the asset has increased. The maximum loss is the premium paid to buy it.
We’ve all got options – what to eat for breakfast, what to wear today, etc. – but options contracts work a bit differently than the usual options we are used to. With options contracts, you’ve got two types: puts and calls. Let’s break it down.
What exactly is an options contract?
Options are financial contracts whose value is based on another financial security, also known as the underlying asset. They give the buyer the right, but not the obligation, to either purchase or sell that underlying asset at a predetermined price before the contract expires.
The underlying asset is usually a publicly traded financial instrument, like a stock, futures contract, equity index (like the S&P 500) or exchange-traded fund (ETF). Since an option’s price is derived from (i.e., based on) the price of the underlying asset, options contracts are known as “derivatives.”
The main reasons investors trade options could include following a specific trading strategy, managing risk and possibly generating income.
Features of an options contract
The key characteristics of options contracts are outlined so that the buyer and seller are aware of these terms before they conduct the transaction. They are:
- The premium, which is the cost to the options buyer to have the right to buy or sell an underlying asset.
- The expiration date, which is the last day that the right to exercise the options contract is valid.
- The strike price, which is the price the investor pays if they exercise the option to buy or sell.
- The amount, which is the number of shares of the underlying asset that can be bought or sold at the strike price.
What is a call option?
A call option gives you (the buyer) the right, but not the obligation, to buy the underlying asset at a specified strike price before its expiration date. You pay a premium to the seller of the option. This per-contract cost is dependent on factors like the price of the underlying asset, the strike price and the time until the option’s expiration date.
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For example, stock options are standardized at 100 shares per contract, so three contracts give you the option to buy 300 shares at a certain price by a certain date. Brokers may also add a fee for options trades on top of the contract premium.
Since call options give you the right to buy, their value rises or falls with the value of the underlying asset.
The risk/reward profile for a call option
In theory, the maximum gain that a buyer of a call option can realize is unlimited because the price of the underlying asset has no upper limit. The maximum loss is the premium you paid to buy the option.
Meanwhile, the seller of the call option is faced with the potential for unlimited risk or loss since the price of the underlying asset could keep on going higher. The most that they can make is the premium they get from the buyer if the buyer decides not to exercise their right to buy the underlying asset.
An example of buying a call option
Let’s say you believe that the price of XYZ stock will be higher in a year, but you are not certain if the price will drop before going higher. Currently, the price is $30 per share. Since you are unsure of its immediate path, you decide to buy a call option that expires a year from now and has a strike price of $32/share. The premium (inclusive of broker fees) is $0.50, which means that to buy one options contract, it will cost you $50 [0.50 * 100 shares].
By buying this call option contract, you have bought the right to buy XYZ at $32 per share before it expires. You will only do this if the market price of XYZ trades at a rate that will generate a profit for you. In this case, that would be $32.51 per share. The break-even point is $32.5 [$32 + $0.50]. So, you will be profitable if the price of XYZ is $32.51 or higher. If it doesn’t trade at this price before it expires, then you will lose the premium, which is $50.
Let’s say that at some point before expiration, XYZ trades at $35 per share, and you exercise your call option to buy XYZ at $32 per share. Your profit would be [($35 - $32) x 100 shares - $50] or $250.
When you buy a long call option, you are buying the right to purchase a security, like shares in a stock or exchange-traded fund (ETF), at a specific price (the strike price) on a specific date (the exercise date) – or by a specific date in the case of American options. The price you pay for this option is called the premium (the price of the call option). This strategy is designed to allow you to potentially buy shares at a below-market price when the price is rising. Alternatively, if the underlying security increases in value, you could sell your long call option for a higher price than you paid for it.
Why might buying a long call option make sense for you?
- You might think that a particular security’s price is going to rise significantly. You might buy a long call based on your views on one sector of the market, the market’s conditions overall or political events.
- You want to have a degree of certainty to an uncertain market situation. No matter how strongly you believe a security’s price will rise, no investor can predict whether, when or by how much. With a long call, you lock the right to buy that security at a specific time within a specified time period.
- You may be able to purchase the security – or sell the call – and make a profit. For example, if your call allows you to purchase the security at $50, and the price goes to $75, you can purchase the security and earn $25 per share when you do. As an alternative, you could sell your call.
What is a put option?
A put option gives (the buyer) the right, but not the obligation, to sell an underlying asset at a specified strike price prior to the option’s expiration date. Put options are like insurance policies. The buyer of a put option can sell an underlying asset at a specific price by a given date, even if the underlying asset is worth less than the strike price.
The premium per contract and any broker fees are similar to those described for call options above.
Since put options give the contract buyer (also known as the holder) the right to sell, their value increases as the value of the underlying asset decreases, and they decrease in value if the value of the underlying asset increases.
The risk/reward profile for a put option
In theory, the maximum gain that a buyer of a put option can realize is the difference between the strike price minus the premium paid and zero. That means the potential profit of a put option is limited by how far down the price of the underlying asset can go, which is zero. The maximum loss is the cost incurred in buying that option, also known as the premium.
The risk/reward profile for the seller of the put option is the opposite. The maximum gain that they can realize is the premium that they receive from the buyer if the buyer does not exercise their right to sell the underlying asset. However, their maximum loss is the difference between strike price minus the premium received and zero.
An example of buying a put option
Say you believe that the price of ABC stock will be lower in a year, but you are not sure if it will go higher before the predicted decline. Currently, the price is $20 per share. Since you are unsure of its immediate path, you decide to buy a put option that expires a year from now and has a strike price of $18 per share. The premium (inclusive of broker fees) is $0.45, which means that it will cost you $45 [0.45 x 100 shares] to buy one options contract.
By buying this put options contract, you have bought the right to sell ABC at $18/share before it expires. You will only do this if the market price of ABC trades at a rate that will generate a profit for you. In this case, that would be $17.54 per share. The break-even point is $17.55 [$18 - $0.45].
So, you will stand to make a profit if the price of ABC is $17.54 or lower. If it doesn’t trade at this price before it expires, then you will lose the premium, which is $45.
Let’s say that at some point before expiration ABC trades at $15 per share and you exercise your put option to sell ABC at $18 per share. Your profit would be [($18 - $15) x 100 shares - $45], or $255.
When you buy a long put, you are buying the right to sell a security, like shares of a stock or exchange-traded fund (ETF), at a specific price (the strike price), on or by a specific date (the exercise date). The price you pay for this option is called the premium. Investors often use long puts to speculate. You don’t have to own the security to buy a put on it.
Why might a long put make sense for you?
- You believe that a particular security is going to lose value. Whether you have a point of view on an industry, political shifts or general market conditions, a long put may be able to help you profit from the decline you anticipate. But if the shares’ value holds steady or increases, you will lose the premium (the full price that you paid for the put).
- Your put may increase in value. If the underlying security’s value declines, you may be able to sell your put at a profit before the exercise date.
- You may be able to exercise your right to sell, if the security decreases and your put is in-the-money, meaning that you’d be able to sell above market price. For example, if your put gives you the right to sell the security at $50 and the price drops to $40, you can make $10 profit if you exercise the put option and use your right to sell for $50. (You have already paid the premium, so that counts against your profits.)
- You might be able to speculate in a controlled way. Instead of trying to guess exactly when market conditions are best for purchasing the security itself, the long put allows you to lock in the right to sell the security at a specific price within a specified time period, without having to actually pay fully for the underlying security.
Types of put and call options
There are many types of put and call options, each with characteristics catering to specific investor preferences and investment goals. Let’s look at some of the major types of options you can expect to see, what makes them unique and investment strategies they may align with.
American
American options, despite their name, have no practical association with specific geography. American options allow you to exercise the option any time before the expiration date, letting you potentially react to market movements and exercising the option when you feel it might be most beneficial. American options are often used when trading stocks, where pricing dynamics may sometimes offer potentially profitable opportunities for option holders.
European
Like American options, European options have nothing to do with geography beyond their name. Unlike American options, European options can only be exercised at their expiration date – not before. This means you must wait until the option’s maturity to exercise it, regardless of how the market moves in the interim.
Exotic
Beyond American and European options, there are a variety of “exotic” options used by investors for highly distinct purposes. Exotic options are highly customized and generally tailored to specific investment goals and investor preferences. These types of options are often used as part of more complex investment strategies or for hedging against specific risks and come in many forms.
Barrier options, for example, are a type of exotic option that becomes activated only if the underlying asset reaches a certain price. Binary options offer a fixed payout based on a simple “yes/no” proposition related to the price movement of the underlying asset. Another type, a ”lookback” option, allows you to “look back” over the life of the option and exercise it based on the asset’s optimal price.
Puts | Calls |
|---|---|
Mechanics | |
Puts give you the option to sell a specified amount of an asset at the strike price within a specified timeframe. | Calls grant you the option to buy a specified amount of an asset at the strike price within a specified timeframe. |
Market outlook | |
Many investors typically purchase puts when anticipating a bearish market or if they expect the price of a particular asset to decline, allowing them to sell the asset at a higher strike price. | Investors tend to buy calls when they have a bullish outlook on the market or a specific asset, expecting its price to increase above the strike price. |
Profit potential | |
The profit potential for puts rises as the price of an underlying asset falls below the strike price, allowing you to potentially sell the asset at a higher price than the current market value. | The potential profit for calls climbs as the price of the underlying asset begins to exceed the option’s strike price, offering you an opportunity to buy the asset at a price below current market value. |
Risk | |
If the market price does not decline as expected and the option is not exercised, put option holders risk the loss of the premium paid for the put option. | Similarly, if the market does not rise as expected, investors may lose the premium paid for the call option. |
Strategy | |
Puts might be used for hedging, protecting against potential losses in your portfolio or for speculation by betting on the asset’s price decline. | Calls might be used for leveraging positions, amplifying gains through an expected price rise of an asset and as a hedge against a price increase for assets you might want to purchase later. |
What are protective puts?
A protective put is a method of options trading that provides risk management. Here’s how they work:
- First, you must own the security, such as shares of a company or exchange-traded fund (ETF). Owning the security is what makes this a protective put.
- Next, you buy a long put on the same security. A long put gives you the right – but not the obligation – to sell the security at a specific price (the strike price) on or by a specific expiration date (the exercise date). The price you pay for the put option is called the premium.
- If the market price drops below the strike price at expiration, you can exercise your option, meaning that you would sell your shares at the strike price. You have protected against any further loss of the shares’ decline. However, you no longer have potential upside of owning the shares.
For example: You own XYZ stock, which is currently trading at $100. You would like to protect against the price dropping significantly in a specific time frame; you may want to limit any potential losses to 20%. You purchase a protective long put, giving you the right to sell at $80. If you paid $100 a share, you’ve limited your loss to $20 plus the cost of the put.
The bottom line
Puts and calls give you the “option” to respectively sell or buy an asset within a specific time at a specific price. You pay a premium for these rights to buy and sell but are not obligated to exercise them. Options are also highly customizable, with various types of puts and calls to choose from. To determine whether options are right for you and your investment goals, consider speaking with a qualified financial advisor for tailored guidance.
Frequently asked questions about puts and calls.
A call is a contract that grants you the option, but not the obligation, to buy an asset if the price hits a specific level by a specific date. A put is an agreement that gives you the option to sell an underlying asset if it reaches a specific price by a specific date. Part of a call or put’s appeal is this ability to pick a future value, purchase the option and then determine whether to exercise it, if and when the price is met.
The biggest difference between a call and a put is the function they each serve. A call works as an option to buy an asset, whereas a put gives you the right to sell the asset if it meets the predetermined strike price. In both cases, you pay the seller of the contract a fee (known as the premium) for the right to hold the option.
You can typically buy put or call options through your brokerage account, provided your broker offers options trading. Different brokers often have their own eligibility rules for options trading, and you may need to seek approval through your brokerage account. Once approved, purchasing a put or call contract means you can choose to either buy or sell the underlying asset (known as exercising the option) if the market value hits the price you have set on your put or call.
Yes, there are various options strategies where you can buy or sell calls and puts of the same stock. For example, the straddle strategy involves using calls and puts of the same expiration date and price for the underlying asset. With a long straddle strategy, the more volatile the market, the greater potential for profit or loss.
The difference between futures and options is that exercising puts and calls is optional, whereas futures are obligations. When you buy a put or call, you have a choice on whether to go through with the purchase or sale. By contrast, with a futures contract, you’re typically obliged to proceed with the purchase once the predetermined conditions are met.
In an options contract, the strike price is the level at which the purchase or sale of the underlying asset will take place if the holder of a call or put option exercises the options contract. You predetermine the strike price when you buy a call or put. In the case of a call, that engagement would be the purchase of the asset. With a put, it gives you the right to sell at the predetermined price.
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Editorial staff, J.P. Morgan Wealth Management
