Call options and put options are derivatives (other examples of derivatives include credit default swaps), which means that their price movements are based on the price movements of other financial products. But what’s the difference between call and put options? Find out everything you need to know about these types of investment options, right here.
What are options?
Before we get started on call and put options, it’s essential to understand, on a more fundamental level, what is meant by the term “option.” Essentially, options are contracts that provide buyers with a right to buy/sell an underlying asset or security at a specific price (referred to as a “strike price”) and by a particular date. Now that you know what an option is, let’s explore call and put options in a little more depth.
Put options explained
Put options are investments that traders will buy if they expect the price of the underlying asset to fall within a specific timeframe.
In this case, the strike price is the price at which traders can sell the underlying asset. For example, buyers of a stock put option with a strike price of £100 can use their option to sell the stock for £100 before the expiration date.
Buyers need to pay a premium for the right to sell the stock at the strike price for a given period. This premium goes to the put seller, which is why writing put options can be an effective means of generating income.
Calculating the cost of the put option is relatively simple. Put options represent 100 shares of the underlying stock. So, to determine the price of the option, simply multiply the underlying share price by a factor of 100.
Call options explained
Call options are investments that traders will buy if they expect the price of the underlying asset to rise within a certain timeframe.
For call options, the strike price is the predetermined price at which the buyer can purchase the underlying asset. For example, traders who have purchased a stock call option with a strike price of £100 can use the option to buy the stock at £100 before the expiration date.
It’s important to remember that unless the current price of the underlying asset is below the strike price, then it isn’t worth using the option, as you could simply make more money by buying the asset on the market.
Just as with put options, buyers of call options need to pay a premium for the right to purchase the stock at the strike price. This premium goes to the call seller.
So, how do you calculate the call option? It’s the same process as for put options. One call option represents 100 shares of the underlying stock, so to find out the cost of the contract, take the price and multiply it by 100.
Understanding the differences between call and put options
As you can see, call and put options represent very different trading instruments. Whereas investors buy call options when they expect a stock to rise, they’ll sell put options when they anticipate a stock to fall. If you want to hedge your portfolio against loss, options can be a viable option, although it’s also worth remembering that call and put options will always have an element of risk. However, if you’re happy to accept those risks, you may be able to reap substantial rewards.
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