What Is a Call Option?
A call option may be contrasted with a put, which gives the holder the right to sell the underlying asset at a specified price on or before expiration.
Why would you buy a call option?
Investors will consider buying call options if they are optimistic—or “bullish”—about the prospects of its underlying shares. For these investors, call options might provide a more attractive way to speculate on the prospects of a company because of the leverage that they provide. After all, each options contract provides the opportunity to buy 100 shares of the company in question. For an investor who is confident that a company’s shares will rise, buying shares indirectly through call options can be an attractive way to increase their purchasing power.
Is buying a call bullish, or bearish?
Buying calls is a bullish behaviour, because the buyer only profits if the price of the shares rises. Conversely, selling call options is a bearish behaviour, because the seller profits if the shares do not rise. Whereas the profits of a call buyer are theoretically unlimited, the profits of a call seller are limited to the premium they receive when they sell the calls.
What Is a Put Option?
A put option is a contract giving the owner the right, but not the obligation, to sell–or sell short–a specified amount of an underlying security at a pre-determined price within a specified time frame. This pre-determined price that buyer of the put option can sell at is called the strike price.
Put options are traded on various underlying assets, including stocks, currencies, bonds, commodities, futures, and indexes. A put option can be contrasted with a call option, which gives the holder the right to buy the underlying at a specified price, either on or before the expiration date of the options contract.
Why would you sell a put option?
Selling (also called writing) a put option allows an investor to potentially own the underlying security at a future date and at a much more favourable price. In other words, the sale of put options allows market players to gain bullish exposure, with the added benefit of potentially owning the underlying security at a future date and at a price below the current market price.
The sale of put options can generate additional portfolio income while potentially gaining exposure to securities you would like to own but at a price below the current market price.
Many F&O traders normally are confused between buying a put option versus selling a call option. Broadly both are bearish strategies and the difference between a call and put option is that while the former is a right to buy the latter is a right to sell. Obviously when you buy an option your risk is limited to the premium you pay. That is because your loss is limited to the premium paid while your profits can be unlimited. On the other hand, when sell an option, your income is limited to the option premium received but the losses can be technically unlimited.
Let us understand the difference between a call and a put with example. Let us also understand how to trade in call and put options, both on the buy side and the sell side.
Call and put option with a live example
Let us assume that the current market price of Tata Steel in the spot market is Rs.695/
ContractCall PremiumPut PremiumITM or OTMNovember 680 Call24.00-ITMNovember 680 Put-7.00OTMNovember 720 Call7.50-OTMNovember 720 Put-28.20ITM
An In-the-Money (ITM) option is one that has intrinsic value and time value. Take the case of the 680 Call Option on Tata Steel. The Call is currently quoting at Rs.24, of which Rs.15 is explained by the intrinsic value of call option (695-680). The balance Rs.9 is the time value. In case of the 680 put, the intrinsic value is zero and so the entire Rs.7 is explained by time value of money.
Let us come to the 720 strike. The 720 Put is currently quoting at Rs.28.20. Of this Rs.25 is explained by intrinsic value (720-695) and the balance Rs.3.20 is explained by time value of money. In case of the 720 call the entire Rs.7.50 is the time value of money.
What determines the economics of buying a put versus selling call?
As we have already seen, you buy put option when you expect sharp downsides in the stock. Therefore, you bet by limiting your risk to the option premium and play for the downside in the stock. You sell call option when you expect that the upsides for the stock are limited. You are indifferent to whether the stock is stable or goes down as long as the stock does not go above the strike price. Before getting into how to trade in call and put options, let us first understand the difference between call and put positions with the example above.
Let us now consider 2 investors viz. Alpha and Beta. Alpha is an aggressive investor who believes that with the metals cycle already overpriced, Tata Steel price should correct. He expects the price to correct to Rs.640 in the next 1 week. He can sell the Tata Steel 680 call and get a maximum profit of Rs.24, which is a good profit on his margin. However, Alpha is taking on a very huge risk here. Since Alpha has sold the 680 Call at Rs.24, he is only covered up to Rs.704. Any price above that will result in unlimited losses for Alpha. The better option will be buying the 680 November Put option. If the price touches Rs.640, then he makes a profit of Rs.33/- (40-7). In a worst case scenario if the Tata Steel stock goes up to any level, his loss is limited only to Rs.7/- share.
Now, let us consider the case of Beta who is more conservative. Beta is of the view that the stock may be hovering in a range. While downsides are open, its upside is limited to Rs.720. The best option for Beta is to sell the 720 call. Buying the 720 put may be too expensive and buying the 680 put may be too out of the money. Selling the 720 call will give him a premium of Rs.7.50 and serve his view.
Buying a put option versus selling a call option: How to decide?
Your decision whether you should buy a put option or sell a call option will be broadly guided by the following 4 considerations:
Are you having an affirmative view on the stock or index going down? In that case it makes more sense for you to buy the put option. Your downside risk will be limited to the option premium paid and your profits in case the stock falls will be unlimited.
Are you having a cautiously non-affirmative view on the stock? In this case you are only confident that the stock price is unlikely to rise beyond a point. You are indifferent to whether the stock price goes down or stays stagnant at current levels. In such cases, it makes eminent sense to sell the call at the strike where you believe the stock to top out. You can also sell a lower call for higher premium but that is taking on unnecessary risk.
Can you pay the margins for the trade? When you buy a put option, your total liability is limited to the option premium paid. That is your maximum loss. However, when you sell a call option, the potential loss can be unlimited. Hence your margining will be exactly like how the margins are imposed on futures. Be prepared for higher capital outlay in this case.
Lastly, are you playing for a rise in volatility or fall in volatility in the market? If you are playing for a rise in volatility, then buying a put option is the better choice. However, if you are betting on volatility coming down then selling the call option is a better choice.
How to trade put and call options is all about knowing the difference between call and put options in terms of risk and return potential. Your choice can actually be a simple one!
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