Futures and options are two derivatives that traders can buy and sell on a stock exchange. Option is a contract that allows the buyer or holder to have the right, but not the obligation to buy or sell an asset for a predetermined price at a specific date.
We have two primary types of options: call options and put options.
Both call and put options are traded in stock exchanges such as NSE, BSE and MCX. Traders use different types of strategies and hedging techniques by using options to make profit in the market.
In this article, we will discuss the difference between a call option and a put option.
What is a Call Option?
A call option is a contract between the seller and buyer to buy an asset at a fixed price on a defined expiry date.
Call option gives the buyer or holder of the contract the right, but not the obligation, to purchase the underlying security. Which means, when you are buying a call option of a stock, you are basically buying the right to purchase that equity share at a specific price (known as strike price) described in the contract on the date of expiry.
On the other hand, the seller of a call option has the obligation to deliver the stock if the contract is exercised by the buyer.
Traders buy call options when they have a bullish view on the stock or market, which means they have expectations that the stock’s price will rise above the strike price.
If the price moves above the strike price, which is lower than the current market price, then the call option holder has two options:
- Either to sell the call option right to some other buyer to profit out of the rise in premium value, or
- Exercise the right of call option to buy shares at the strike price and sell them immediately at the current market price to make profit.
Risk of the buyer and seller in a call option
The person who writes or sells the call option contract is known as a seller. The person who buys the right on call option contract from the seller is referred to as buyer or holder of the contract.
When the writer sells a call option, he or she receives a premium from the buyer for promising to sell the underlying asset at the strike price on the date of expiry. Which means the buyer has the right to buy shares from the seller at the strike price on the expiry date mentioned in the contract.
If the price of the underlying asset goes up above the strike price, then the buyer will be interested to exercise his or her right to buy as he is buying at a lower price than the current market price. The difference between the current market price minus strike price minus the premium received is the loss that seller has to take.
Seller of a call option has unlimited risk as there is no limit how far a stock’s price can go up before expiry. To avoid this kind of risk, many sellers prefer hedging by using a covered call strategy.
In a covered call strategy, you basically own the shares at a better price and by selling at a discounted price, you are foregoing a big profit.
If you are selling a call option of a stock that you don’t own, then it will be considered as naked call, in which if buyer exercised his right, then the seller will be forced to buy shares at a higher price and sell them at a lower strike price as per the contract by incurring a huge loss.
Instead of going up, if the price of the underlying asset goes down, then the buyer will not exercise his or her option as market price is below the current market price. In this case, buyer loss will be restricted to the premium paid, which is a gain for the seller.
Example of call option
Suppose Mr Kumar wants to buy an option for stocks of a listed company ABC limited. Current market price of ABC limited stock is Rs 100 per share. Mr Kumar has a bullish view on ABC limited, which means he is expecting share prices of ABC limited to rise, therefore he decided to buy a call option contract with a strike price of Rs 105 per share.
To buy the call option contract, assume that Mr Kumar has paid Rs 250 as premium for 250 shares.
Mr Kumar will be in profit when the price of ABC limited is above Rs 106 per share (Rs 105 as strike price + Rs 1 as premium).
If the share price of ABC limited does not move above the strike price, Mr Kumar will prefer not to exercise the call option. In this case his loss will be the premium paid i.e. Rs 250.
In case the share price of ABC limited rises to Rs 110, then Mr Kumar will exercise his rights to buy at Rs 105. After buying, he can sell it at a higher price to earn profit.
What is a Put option?
Put options give the buyer or holder the right but not the obligation to sell the underlying security.
A trader buys a put option when he or she has a bearish view on the underlying stock or market. Which means that the trader is expecting the current market price to fall to a certain level within a short period of time.
When the underlying stock’s market price falls below the strike price, the buyer of put option has following two options:
- Either to sell the put right option to another buyer at a higher price to make profit, or
- Exercise the right by selling shares at a strike price, which is higher than the current market price to make a profit.
Risk of buyer and seller in put option
A put option seller incurred a limited risk up to the strike price multiplied by the number of shares included in the contract and then subtracting the premium received.
When a writer sells a put option contract to the buyer, he or she basically gives the option holder the right to sell shares at a strike price on the date of expiry as mentioned in the contract.
If the underlying stock’s price falls below the strike price mentioned in the contract, then the buyer of the put option will exercise the contract, in which the seller has to buy the underlying stocks at the strike price which is higher than the current market price.
Underlying stock’s price can go down to zero. If that happens, on exercise of the contract, the seller will buy the stocks at the strike price for worthless securities incurring huge loss. As the underlying stock’s price can’t go below zero, the seller risk is often specified as limited risk.
Loss of the buyer of a put option is restricted to the premium paid as the buyer has no obligation to exercise the contract.
Example of Put Option
In our above example, suppose Mr Kumar has a bearish view on the stock of ABC limited. Therefore, he decided to buy the put option of ABC limited stock.
Suppose, he purchased a put option contract with strike price of Rs 95 by paying Rs 250 as premium covering 100 shares.
If stock of ABC limited falls below the price of Rs 95, then Mr Kumar will exercise his right to sell the stock at the strike price of Rs 95 for profit. Suppose the price of ABC limited comes down to Rs 80. In this case Mr kumar will earn Rs 1,250
((Strike price – Current share price)*100 – Rs 250) = ((Rs 95- Rs 80)*100 – Rs 250) = (Rs 1500 – Rs 250) = Rs 1,250
If ABC limited stock’s price does not fall below the strike price i.e. 95, then Mr Kumar will not exercise his rights. In this case, his loss will be restricted to the premium paid i.e. Rs 250.
Call Option vs. Put option: What is the difference?
| Particulars | Call Options | Put Options |
| Power of buyer | Buyer has the right but not the obligation to buy the underlying asset at a fixed price at a future date. | Buyer has the right but not the obligation to sell the underlying asset at a fixed price at a future date. |
| Power of seller | Seller is obliged to sell the underlying asset if buyer exercised his or her rights | Seller is bound to buy the underlying asset if buyer has exercised his or her rights. |
| Risk of buyer | Call option buyers’ risk is limited to the premium paid. | Put option buyer has limited risk up to the amount of premium paid. |
| Seller’s risk | Seller risk is unlimited as technically the price can go to infinity. | Seller has limited risk which is equal to the strike price multiplied by the number of units involved. |
| When buyer makes money | Call options will generate profit for the buyer when the value of the underlying asset is rising upwards above the strike price. | Put options will generate profit to the buyer when the value of the underlying asset is falling below the strike price. |
| When seller makes money | The writer of a call option will have a view while writing that the stock price will not go above the strike price. For the seller the break even point is strike price plus the premium received. If the underlying asset closes below the strike price, then the entire premium will be the seller’s profit as the buyer will not exercise his or her rights. | The writer of a put option will have a view that the underlying asset’s price will never go below the strike price. The break even point for sellers is the strike price minus the premium received. If the underlying asset closes above the strike price, then the entire premium is the seller’s profit. |
Frequently Asked Questions (FAQs)
When do traders generally exercise put versus call options?
In general, buyers of put and call options exercise their contract when they are in the money (ITM).
A put option will be in the money, when the price of the underlying asset is below the strike price.
A call option will be in the money when the stock’s price is above the strike price of the option.
How much money is made in a call option?
As a seller, when you sell a call option, you earn the premium. If the option contract expires unexercised, then the whole premium earned is your profit. If the direction of the underlying asset’s price moves in opposite to your expectation, then losses can be unlimited depending how far prices move against you.
Buyer losses will be restricted to the premium paid. If the underlying asset moves in your favor then profit potential is unlimited.
What are ATM, OTM and ITM in options?
OTM means Out of the Money. In a call option contract, if the spot price is less than the strike price, then it is called Out-of-the-money or OTM option. In a put option, if the spot price is greater than the strike price, then it is called out-of-the-money or OTM put option.
ITM stands for In the money. If the call option’s spot price is greater than the strike price, then it is known as in-the-money or ITM option. In the case of a put option, if the spot price is less than the strike price, then it is called in-the-money or ITM put option.
ATM stands for At the Money. In a put and call option contract, if the spot price is equal to the strike price, then it’s referred to as At-the-money or ATM option.
What are option premiums?
Option premium is the amount that the buyer pays to the seller for buying the right on a put and call option contract. When someone is interested to trade in a put or call option contract based on a strategy, the price that they pay for the right is called the option premium.
In stock exchange, option premium is influenced by 3 factors: price of the underlying contract, level of volatility and time to expiry.
What are CE and PE in the stock market?
CE stands for Call European. PE stands for Put European.
We have two styles of option contracts: American and European.
If an option contract can only expire at expiration date, then it’s a European style. Instead, if the option contract may exercise at any time before the expiry date, then it’s an American style.
In India, we follow European style equity, index and all other option contacts. In the US, they follow both American and European styles.
