When it comes to trading options, calls and puts are the two most common types of contracts used. Calls and puts are essentially contracts that give the owner the right, but not the obligation, to buy or sell an underlying asset at a predetermined price, called the strike price, within a certain time period, known as the expiration date. In this article, we’ll take a closer look at how calls and puts work.
Calls
A call option gives the owner the right, but not the obligation, to buy an underlying asset at a specified strike price within a certain time period. If the price of the underlying asset rises above the strike price, the owner of the call option can exercise their right to buy the asset at the lower strike price and then sell it at the higher market price, thus making a profit.
For example, suppose you purchase a call option for 100 shares of XYZ stock at a strike price of $50 per share with an expiration date of one month from now. If the price of XYZ stock rises to $60 per share before the expiration date, you can exercise your call option to buy 100 shares at the strike price of $50 per share and then sell them on the open market for $60 per share, making a profit of $10 per share.
However, if the price of XYZ stock does not rise above the strike price before the expiration date, the call option will expire worthless and you will lose the premium paid for the option.
Puts
A put option, on the other hand, gives the owner the right, but not the obligation, to sell an underlying asset at a specified strike price within a certain time period. If the price of the underlying asset falls below the strike price, the owner of the put option can exercise their right to sell the asset at the higher strike price and then buy it back at the lower market price, thus making a profit.
For example, suppose you purchase a put option for 100 shares of XYZ stock at a strike price of $50 per share with an expiration date of one month from now. If the price of XYZ stock falls to $40 per share before the expiration date, you can exercise your put option to sell 100 shares at the strike price of $50 per share and then buy them back on the open market for $40 per share, making a profit of $10 per share.
However, if the price of XYZ stock does not fall below the strike price before the expiration date, the put option will expire worthless and you will lose the premium paid for the option.
In summary, calls and puts are options contracts that give the owner the right, but not the obligation, to buy or sell an underlying asset at a specified strike price within a certain time period. Calls are used when the owner believes the price of the underlying asset will rise, while puts are used when the owner believes the price of the underlying asset will fall. As with any investment, trading options carries risks and it is important to understand the mechanics of how calls and puts work before entering into any trades.