An option is a contract that gives its holder the right to buy or sell an asset within a specified time frame and price. There are two fundamental types of options that we’ve analyzed: Call Options vs Put Options. A call option gives the holder the right to buy shares of a security at a set price by a set date. A put option, on the other hand, gives the holder of the contract the right to sell shares of a security at a set price by a set date.
Call Options vs Put Options
Call Options
Call options give the option holder the right but not the obligation to buy the underlying stock at a predetermined price (known as the strike price) by a specific date, known as the option’s expiry date. They’re a type of option that increase in value when the underlying stock rises and are one of the most popular types of options.
For this right, the call option buyer would pay a “premium” which the call option seller will receive. In contrast with stocks, options have an expiry date where on that date, they may expire worthless or be exercised.
The major components of an option are
- Strike Price – The strike price is the price that you are allowed to buy the underlying stock
- Premium – The price of the option that an individual would pay
- Expiration Date – The expiry date when the option expires and is settled
Each option is known as a contract and each contract represents a claim of 100 shares of the underlying stock. Option prices are quoted in terms of per share price and not the total price that you may pay.
For example, Jim is planning to buy 1 option of American Airlines. The price is quoted at $0.85. His total premium to purchase one contract will cost $85. (100 shares x 1 contract * 0.85)
Call options may be in the money or out of the money. They’re considered in the money when the stock price is above the strike price at the expiration date. The owner of the option can exercise the option by utilizing cash to buy the stock at the strike price. If the owner of the option is not interested in exercising the option, they can sell it another buyer.
For example, Jim has 1 option of American Airlines with a strike price of $50. The stock is currently trading at $55 per share. Jim has the option to buy 100 shares of American Airlines at $50 by exercising the option and utilizing cash to purchase the shares. By exercising the option, Jim can go ahead and sell the shares at $55 each.
It’s important to factor in the premium as well. Jim would profit if the premium paid is less than the difference between the stock price and the strike price. For example, he bought the call at a price of $0.85 with a strike price of $50. The stock is currently $55. The option is $5. Jim would have made a profit of $4.15
If the price of the stock is below the strike price at the expiry date, then the option would be out of the money and expire worthless. The seller who sold the option would keep any premium that they received for the option.
Put Options
Put options are the opposite of call options. They give you the right but not the obligation to sell a stock at the strike price by the option‘s expiration date. The value of put options increase as the price of the stock falls.
To purchase a put option, the buyer would pay the seller of the option a premium. At the expiry date, the option may be settled or expire worthless.
For example, Jim is looking to purchase 1 put option on American Airlines. The price of an option is currently $1.50. As each contract option represents a claim of 100 shares of the underlying stock, the total cost for Jim to buy 1 option contract of American Airlines would be $150. (100 Shares * 1 Contract * $1.50)
Put options would be considered in the money when the stock price is below the strike price at the expiration date. At that date, the owner of the put option may exercise the option or sell it at the fair market value.
Jim would profit on his American Airline put if the premium paid is lower than the difference between the strike price and the stock price. Jim purchased the put option for $1.50 with a strike price of $50. The current price of American Airlines is $45 at expiration. The option is worth $5 meaning the Jim has made a profit of $3.50. He can choose to exercise the put contract and sell his shares shares at $50 each when the stock price is trading at $45.