Call Option vs Put Option – Introduction to Options Trading
This article will cover everything you need to know about call option vs put option, and what the top 3 benefits of trading options are. We'll also share the risks you take when you trade call and put options.
Our team at TSG puts a lot of weight on the financial education of our readers, so we’ve decided to touch on the call vs put option topic and how you can make insane returns from them.
Options in the stock market can make you more money than you ever dreamed possible, make you lose money, or save you more money than you ever dreamed. As you can guess, it’s extremely important to get proper education on this subject if you ever considered trading options.
If you’re a stock market beginner, you need to know all the basics around what the options are. We’re aware that many of our readers have asked for this article. Our team is composed of experienced options traders so we’re going to give our best to break down what is a put option vs call option for you the beginners.
In the first part of this options trading guide, you will learn the definition of put and call options, and then we’re going to highlight the top three advantages of trading options.
Definition of Put and Call Options
The call and put options are the building blocks for everything that we can do as a trader in the options market. There are only two types of options contracts, namely the call vs. put option.
Let’s dig deeper…
A call option is when you bet that a stock price will be above a certain price on a certain date. For example, if the Apple stock price is $100, you’re going to place a bet that Apple stock price will be at least $110 by, let’s say, September 2018. So, if the Apple stock price is above $110 by September 2018, you make money. The $110 stock price is also called the strike price.
*Note: The strike price is simply the minimum amount that a stock needs to be at before the option expiration date.
A put option is the exact inverse opposite of what a call option is. You’re placing a bet that a stock price will drop to a certain price by a certain date. If the Apple stock price is $150 and you bet that it’s going to be under $130 a share by October 2018. If the Apple stock price drops below $130 by October 2018, you make money.
Now that we’ve learned the definition of put and call options, let’s have a more in-depth look at how call and put options work. In this regard, we’re going to look at understanding how to buy call options.
Long Call Options Strategy
The long call option strategy is the simplest options strategy. When you go long, you buy a call option with the expectation that the stock price will rise past the strike price before the expiration date.
In our base case scenario, we’re going to look at buying 50 call option of XYZ stock (see diagram below).
The point where the payoff diagram pivots and moves higher is the point where you’ll start gaining a profit. Your expectation is that the stock price is well above the $40 price sometime in the future before the expiration date.
Let’s say right now the stock price is at $40, you’re going to hope that it’s beyond $50 because that’s your strike price. You need the stock price to be beyond that price point in the future for you to make money.
These are very easy to set up since it’s just a single option order. You simply buy a call option with the strike price and expiration date you desire.
If the stock is trading at $50 and you buy the $50 strike calls, then you bought an at the money option or ATM options.
If the stock was trading at $40, and you would buy the $60 strike calls in which case you bought an 'out of the money' option or OTM options. When the stock price isn’t at the strike price you buy OTM options. The more bullish you are on the stock price, the further OTM you can buy the call option.
*Note: Where you buy the option determines the type of option you bought.
Now, compared with buying the stock shares from a stock exchange, options give you the power of using leverage. You can control with 1 contract of Call options 100 shares of stocks. With the options, we have power and leverage and we can kind of pick our price points.
Loss is Limited when Buying Call Options
During call option strategies, the maximum loss is always limited. If the stock is below the strike price at the expiration date, the call option will expire worthless, and the loss would be the price paid for the call option.
In our example, we assumed that the price you paid for the call option is $200. If you’re predicting the stock price will be well beyond the $50 strike price, then you can buy the stock at $50, using this call option and resell the stock immediately in the market for whatever the current price is, netting you a profit.
However, if at the expiration the stock price is below the strike price, then there would be no reason for you to go out and buy the stock at $50 when currently it’s only worth $40 in the open market. You just wouldn’t exercise your option contract. You would actually go out, and if you wanted the stock you would buy it at the current market price of $40 per share.
This is where some of the reduced risk features of options trading come into play.
Profit Potential is Unlimited when Buying Call Options
In call option strategies, the potential profit is theoretically unlimited. It’s only limited by how high the stock price can go.
Obviously, we say theoretically unlimited profits, but, you know, options prices are going to be range bound, within certain parameters and there’s no stock price to rise to infinity.
The Importance of Volatility in Options Trading Strategies
Volatility also plays a big role in how options are priced. An increase in implied volatility does have a positive impact on the strategy. As a general rule, the advantage of the long option strategy is that volatility tends to boost the value of the option because there is a higher probability the stock price to trade above the strike price at the expiration date.
If the market is more volatile, we have a stock that sitting at $50, and it’s a good chance to swing between $40 and $60, then there is a good chance this option contract might be more valuable.
However, if the stock price is at $50 and the market is not volatile enough to move more than a couple of pennies per day, then the value of this option contract is going to be down because there is not a high probability for the stock price to swing into a potential profit zone.
Time Factor in Options Trading Strategy
Both call options vs. put options have a finite life, and as they go quicker and quicker toward expiration, the value, or the time left for the stock to move into a favorable profit zone, is going to be less and less.
Once the time value fades, then all that remains are the intrinsic value of the stock, so the difference between the strike price and the current price of the market.
Conclusion - Call Option vs Put Option
The main advantage of buying call option vs. put option is the limited risk associated with buying options strategies. You can also control 100 shares of stocks with far less money than you could if you bought the stock directly. The combination of having limited risk in combination with enormous upside potential makes options trading one of our favorite ways to speculate on the stock market.
In order to decide what you should buy between call vs. put option, you can use and apply the same technical tools or trading strategies that you use when you trade the stock market, Forex market or the cryptocurrency market.
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