Nihal PS Derivative investments include put and call options. The price movement of their product is
based on the price movement of another financial product.
We’ll explain what these options mean and how traders and buyers use them. The product on
which a derivative is based on is referred to as the “underlying.”
Defining and illustrating call and put options
The term ‘options’ refers to contracts in which a buyer has the right to buy or sell the underlying
asset, or the security upon which a derivative contract is based, at a specific price and by a set
date.
It’s the amount at which a derivative contract can be purchased or sold. The strike price
is often referred to as this.
· Traders buy call options when they expect the price of the underlying asset to rise within a
certain period of time.
· Put options are purchased when the trader expects the price of the underlying asset to fall
within a certain time frame.
It is also possible to write put and call options and sell them to other traders. Buying the option
generates income, but it gives up some rights to the buyer.
A brief explanation of call options
An American-style call option is an option contract that gives the buyer the right to buy the
underlying asset at a set price at any time until the expiration date.
European-style options allow buyers to buy the underlying asset only when the option expires.
There are short-term and long-term options.
Call options have a strike price in which the buyer is able to buy the underlying asset at a
predetermined price. A buyer of a stock call option with a strike price of $10 can buy the stock at
the strike price before the option expires.
When the current price of the underlying asset is above the strike price, the call buyer should
exercise the option and require the call writer/seller to send them the stock at the strike price. It
doesn’t make sense to exercise the call option to buy the stock at $10, for example, if the stock
trades at $9 on the stock market, since they can buy it for a lesser price on the stock market.
What the call buyer receives
Call buyers are entitled to purchase stock at a strike price for a specified period of time. The
premium they pay is based on the strike price. A call option will have intrinsic value if the strike
price is above the underlying asset’s price. It’s possible that the purchaser can sell the option for
a profit, which is what many call buyers do, or they could exercise it (i.e., receive the shares
from the writer of the option).
This is what the call seller receives
The premium is paid to the call writer/seller. You can earn income by writing call options. An
option writer can only earn income if he or she writes a call option. In theory, a call buyer can
make unlimited profits.
100 shares of the underlying stock are represented by each call option contract. Shares of the
underlying stock are typically quoted per call. Take the option price and multiply it by 100 to
figure out the cost of purchasing the contract.
In-the-money, in-the-money, and out-of-the-money call options:
· A call that is “in the money” means that the underlying asset price is higher than the strike
price.
· “Out of the money” refers to underlying prices below the strike price.
· An option that is “at the money” means that the underlying price is the same as the strike
price.
A description of how put options work
The opposite of a call option is a put option. U.S.-style put options give the holder the right to
sell the underlying asset at a set price at any time before the expiration date. European-style put
options can only be exercised by selling the underlying asset on the expiration date.
A strike price is a price at which a put buyer can sell the underlying asset at a predetermined
time. stock put options, for example, with a strike price of $10, allow their buyer to sell the
stock at that price before the option expires.
Exercise of a put option (and the requirement that the put writer/seller buy the stock from the put
the buyer at the strike price) is only practical if the underlying asset is currently trading below the
strike in the example above, if the stock is trading at $11 on the stock market, it is not worth
the put option buyer’s time to exercise their option to sell it at $10, as they can do sol it for a
higher price on the market.
What the put buyer receives
For a set amount of time, a put buyer has the right to sell a stock at the strike price. The
premium is paid to secure that right. The option will have intrinsic value if the price of the
underlying asset falls below the strike price. If the buyer exercises the option, he can sell for a
profit, which is what many put buyers do.
What the put seller receives
The premium is paid to the put seller or writer. Putting output options is a good way to make
money. In contrast, a put seller can only earn the premium from a put option, whereas a put
buyer can continue to profit until the stock reaches zero.
How to calculate the put option’s value
Just like call option contracts, put contracts represent a 100 share underlying stock. Multiply the
the share price of the underlying asset by 100 to determine the price of the contract.
Call options can be in the money, at the money, or out of the money, just like put options:
· A put that is “in the money” means that the underlying asset price is below the strike price.
· The underlying price is above the strike price when the option is out of the money.
· A strike price and underlying price are at the same level if the option is “at the money”.
As with call options, put options can be bought at any time and buyers will pay a higher
premium when they are in the money because the option already has intrinsic value.
The difference between call and put options
In order to function as effective hedges, call options and put options should limit losses and
maximize gains. Assume you bought 100 shares of Company XYZ’s stock, expecting it to rise to
$20. As a result, you invested $1,000. A put option with a strike price of 10 for a total of $2 is
purchased to hedge against a potential decline in the stock price (each option contract
represents 100 shares of the underlying stock).
Think about the situation when the stock price increases to $20 (i.e., it goes up to $20). Put
options expire worthless at such a point. However, your losses are limited to the amount of the
premium you paid (in this case, $200). Your maximum gains will also be limited if the price
declines (as you bet in your put options). It means that you cannot make more money than what
you make following the stock’s price’s fall to zero, since the stock price can’t fall below zero.
Consider a scenario in which you’ve bet that the stock price of XYZ will decline to $5. You have
purchased call options in order to hedge against this position, betting that the stock’s price will
increase to $20. Would it matter if the stock price went your way (i.e., decreased to $5)? You will
lose $200 on your call options if they expire worthlessly. Once XYZ takes off, its price has no
upper limit. XYZ could theoretically go as high as $100,000. As a result, your gains are not
limited.
Puts and calls: Application of options
A call or a put is primarily used as a risk management tool for existing investments.
Investors who own stock, for example, often buy and sell options on the stock to hedge
their direct investment in the underlying asset. As a result of his investment in options, at
least some losses in the underlying asset may be compensated. However, options may
also be used for speculative purposes in isolation.
Hedging by buying puts
Stock put options allow investors to buy a stock at a discounted price if they believe its price
may drop but wish not to abandon their investment for the long term. Profits from the put
options will offset losses from the actual stock if the stock drops in price.
During uncertain times, such as earnings season, such a strategy may be employed. In order to
protect a well-diversified portfolio, they may buy puts on individual stocks or index puts.
Managers of mutual funds frequently utilize puts to limit a fund’s downside exposure.
Speculation – Sell puts or buy calls
An investor who believes a security’s price will rise may buy calls or sell puts to take advantage
of the price rise. The total risk to the investor in buying call options is determined by the
premium paid. However, theoretically, their profit potential is unlimited. The price difference
between the market price and the strike price of the option is determined by the number of
options held by the investor.
The situation is reversed for the seller of a put option. His potential profit is limited to the
premium he received for writing the option. Their loss is unlimited – equal to the difference
between the market price and the option strike price times the number of options they own.
Speculation – Sell call options or buy puts on bearish
securities
By selling calls or buying puts, investors can benefit from downward price movements. Call
writers can only profit from the premium on their call. A put buyer has more upside potential, but
can only lose a certain amount if the option’s price drops. When the market price of the
underlying security falls below the strike price of the option, the put buyer is rewarded. The
investor only loses the premium if the hunch was wrong and prices do not fall.
With options, how do you measure risk?
The Greeks, also known as the Delta, Theta, Gamma, and Vega, are four different dimensions
used to measure risk in options.
What Are the Three Important Characteristics of Options?
The three important characteristics of options are as follows:
· Strike price: This is the price at which an option can be exercised.
· Expiration date: This is the date at which an option expires and becomes worthless.
· Option premium: This is the price at which an option is purchased.
What is the tax treatment of options?
The taxation of call and put options depends on the duration during which they are held. These
options are taxable. Beyond that, the specifics of taxed options depend on their holding period
and whether they are naked or covered.
The most important Takeaways
· Call options are purchased by traders who expect the price of the underlying asset to rise
within a specified period of time.
· Put options are purchased by traders who expect the price of the underlying asset to fall
within a specified time period.
· A strike price represents the price at which a put or call option can be bought or sold.
· Options contracts are connected to 100 shares of the underlying stock
