How Calls and Puts Work
At OptionsGeek, we focus on buying options. Using two examples, I'll show you how Calls and Puts work within that context.
There are the two classes of options, Calls and Puts. Before going through each class in more detail, let’s bring back the terms we outlined earlier in “What are Options?”:
- Stock Price: The underlying asset represented by the option.
- Options Class: Whether Calls or Puts.
- Strike Price: The Price where the exchange of stock happens at the Expiration Date given certain stipulations in the contract referring to where the Stock Price is relative to the Strike Price.
- Expiration Date: The date that the option contract expires at the close of market hours.
- Options Premium: The cost to the buyer of the Options on a per-share basis.
- Multiplier: The amount of shares represented by one options contract.
Example: 100 shares
These terms are very important to remember. They will be used throughout your education, so make sure you spend a few minutes to fully understand them.
How Call Options Work
Calls give you the right to BUY a stock at a certain price (Strike Price) until a certain date (Expiration Date).
If you BUY CALLS then you want the stock to go up as much as possible. Why?
Because you have a contract that gives you the right to buy it at a certain price. And the higher the stock goes, the better off you are.
Keep in mind, if you own a Call Option, you’re not obligated to BUY the stock.
Foe example, assume you have the Right to Buy a stock at $195. If the stock price is currently at $180, would you want to buy the stock at $195????
Of course not.
You would only choose to buy the stock if it was above $195 at the expiration date.
Exercise Your Right
However, if you choose to BUY the stock via the call option then it’s called “exercising your right.” In order to exercise your right, you will need the amount of capital necessary to actually buy the shares of stock.
Most times, options are not exercised and not held until the expiration date, they are simply sold back into the market before that day arrives. Profit and loss can be made by simply buying and selling the options contracts at different market prices, exactly how you would do it with stocks.
***Note: If the stock offers a dividend, then there are times that you might exercise the Call options prior to expiration.
How to Trade Call Options
Here is an example of a Facebook (FB) Call Option order.
Today is August 30th and FB stock is $185.67.
You buy 3 FB Call Options contracts that expires on September 20th.
The Strike Price is $195, which means you have the right to buy FB at $195 no matter where the stock goes.
Each option costs $1.75. This makes the total amount of options premium you pay today $525.00 ($1.75 x 3 contracts x 100 multiplier). Don’t forget the 100 multiplier!
Let’s assume the stock price increases and the option premium also increases to $3.00.
If you decide to sell the 3 contracts, then your profit would be $1.25 per contract, or $375 ($1.25 gain X 3 contracts X 100 multiplier = $375). Again, remember that each contract represents 100 shares, so you will need to multiply the profits per contract by 100.
Hopefully, that wasn't too difficult to follow. While this example shows you how to trade call options, it doesn't get into how to trade call options with an advantage. We'll save that for later.
Now, let's think about how put options work continuing with FB as our example.
How Put Options Work
Call Options are usually easier to understand. But, it is equally important to understand how put options work.
Similar to Call Options
Besides the directional risk, Calls and Puts work in a similar manner. While Call options focus on the upside risk to the stock price, Puts focus on the downside risk.
Just like the Call Option, when buying a Put option you receive "rights."
Put Options give you the right to SELL a stock at a certain price (Strike Price) until a certain date (Expiration Date).
As a Put Option Buyer, you are not obligated to SELL the stock.
If you choose to SELL the stock via the put option then you are “exercising your right.”
Like Calls, Puts can be bought and sold for profit in the market prior to exercise or the expiration date. Most put buyers do not exercise their options and do not hold them until expiration.
They simply sell the puts back into the market.
#1 Put Question
Many beginners ask the question:
“What if I don’t own the stock, can I buy a put?”
Or a variation of that is:
"How do I sell something that I don't own?'
Remember, a Put Option is simply a contract (In the Step 1 Value I use post-its to make sure you realize it's just like any contract written on a piece of paper).
So, just because you own the Put Option doesn’t mean you have to SELL the stock (in this case one that you don’t own). The Put Options has value and there is an active market for that put option. You can find that value on what's called the Options Chain.
How to Trade Put Options
Here is an example of a FB Put Option order:
This assumes that you buy 2 FB Put Option contracts that expire on September 20th.
The Strike Price is $180, which means you have the right to SELL FB at $180 no matter where the stock goes. If it goes to $0, you still get to sell it at $180.
Each option costs $2.37. This makes the total amount of options premium you pay today $474.00 ($2.37 x 2 contracts x 100 multiplier). Don’t forget the 100 multiplier!
If the stock trades lower and the Put Option's premium rises to $3.45, then you could sell the put in the market or hold it. Even though you don’t own shares of FB, you can own the puts and profit from a decline in the stock price.
More details about how to trade Call and Put Options like the Top 1% will come a bit later. But first, let’s continue the discussion about “Direction.”
Did you know that there are three different directions when using options?