You’ve probably heard of options and their meteoric rise to prominence if you’ve been following finance news for the past few years.
According to the Options Clearing Corporation, 2021 had the highest volume of options trading volume, while 2022 had the second-highest.
Robinhood is a low-cost and mobile-friendly trading platform that has seen a surge in popularity. Even if you don’t know what options are or how they work, almost anyone can trade them.
Options trading is complex and can be a confusing world. Many beginners can find it confusing to understand one of the most basic concepts, the call vs. placed distinction.
What is the difference between calls and puts?
Calls and puts are two types of options contracts. Both have a buyer or a seller.
While most financial markets only have buyers and sellers, the options market can accommodate four types of participants: call buyers, sellers, buyers, buyers and sellers.
Writing an option is also called “writing an option”. This refers to selling an option at its source, rather than reselling a call or put you purchased.
You pay a small amount, called the “premium,” when you purchase a call. In exchange, you have the right to buy the underlying stock at a fixed price or the strike price on or before a certain date or expiration. ”
A put purchase is similar to buying a stock option, but it allows you to sell the underlying stock at strike price before or on expiration.
Calls can be profitable for buyers or “in the cash” when the market price for the underlying stock exceeds the strike price. This is because exercising the option or buying the stock at strike price would result in the stock being less valuable than its actual value.
Puts can be profitable for buyers if the underlying stock trades below the strike price. This is because exercising the option would result in the stock being sold for more than its value.
Puts and calls have more than buyers. They also have sellers.
If you make a call, the buyer pays you the premium and you agree to sell the underlying stock at the strike price to them.
Call sellers hope this doesn’t happen. If the buyer exercises the option and it is still in the bank, the seller must give the stock to the buyer for less than its value. If the option is not in the money and the buyer does not exercise it, the seller will keep the premium but no action.
If you sell a put you receive a premium and, in return, you agree to purchase the underlying stock of the buyer at strike price if they exercise their option before expiration.
Put writers hope that the strike price of the underlying stock trades higher than the strike price, so the option expires and is worthless. They can still keep the premium. If the buyer exercises the option and it is still in the money, the put seller must buy the underlying stock for more than its current market value.
The market participants in the four options markets and their incentives
Buying put options vs. calling options
Call options are bought by traders when they feel the stock is a good investment and can make bigger profits than if they own the stock. Call buyers can exercise the option or resell it for a profit if the stock trades above the expiration price.
Buying calls can be used to “double down” on stocks you already own, or for speculation on stocks you don’t yet own.
Although call buying requires a lower initial investment than buying shares of the stock, it can still result in a significant loss of your entire investment. The call will be canceled if the stock’s value is less than the expiration strike price.
To bet against a stock, traders often buy puts on stocks. It is preferred to short selling, which can be used to place a bet against a stock. If the stock rises enough to cause short selling losses, they can reach 100%. Put buying could result in losing 100% of your investment.
>> Learn more about short selling.
A “protective put” strategy is where a trader buys a put on a stock they already own. Usually, they pay less than the stock’s purchase price. This way they “win” no matter what stock does.
If the stock goes up, they can let the put expire and make profits by selling the underlying stocks, less the premium paid. They can then exercise their put or resell it for a profit to offset any losses they may have from the stock falling.
Writing call options and writing put options
Option writing is often part of a more complex strategy than simply placing a positive or negative stock bet. Options traders often sell options to make income or protect their stock investment from losses.
A covered call strategy is where a trader will sell out-of-the money calls on stock that they own. The call will be canceled if the stock price falls below the strike price prior to expiration. This income could offset losses in the underlying stock.
In theory, traders could also sell naked calls on stocks that they don’t have, but this is very risky.
The seller must be able immediately to purchase the underlying shares at market price, and then to sell them to the buyer at the lower strike price if a naked option is exercised. A bad naked trade can result in a loss of investment and less cash for the seller.
This loss could be unlimited if the stock continues to rise.
Traders often sell out-of the-money puts on stocks that they believe have potential. Stocks they believe will rise over time. The put expires if the stock’s value remains above the strike price at expiration. The seller can keep the premium.
The seller will be “assigned or put” the stock if it falls below the strike price.
This means that they will have to purchase it at the strike price. This is usually higher than the market. Although it isn’t the best option, if the trader believes the stock will rise significantly over the long-term, they may still consider the strike price to be a bargain.
Naked call selling and put selling have important limitations. Both require that you have sufficient money (or margin) in your account to buy the stock immediately — at the market price for a bad naked sale or at strike price for a bad put.
Many brokerages have a set margin for writing put and call options.
Do you want to trade options?
Options trading may be right for you depending on many factors. These factors include your financial security, investment goals, and risk tolerance.
Options trading comes with risk. The Securities and Exchange Commission recommends that you learn how options strategies work before you invest. If you are able to pay your bills and have an emergency fund or you are saving for retirement, and you know the risks involved in options trading, you may be able to sell and buy puts and calls with as much money as you can afford. You might even win big.
If you do not meet these conditions, trading volatile assets like options may not be the best option. If you are unsure whether options trading is right for you, it’s a good idea consult a financial adviser.