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JeFreda R. Brown is a financial consultant, Certified Financial Education Instructor, and researcher who has assisted thousands of clients over a more than two-decade career. She is the CEO of Xaris Financial Enterprises and a course facilitator for Cornell University.
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Options are derivatives that allow investors to exchange the right to buy or sell a specific security at a specific price. There are two primary types of options: call options and put options.
Call options give the holder of the contract the right to purchase the underlying security, while put options give the holder the right to sell shares of the underlying security. Both can be used to let investors profit from movements in a stock’s price. However, there are very important differences in how they work. Here are some examples.
| Call Options | Put Options |
|---|---|
| Gives the holder the right to buy shares | Gives the holder the right to sell shares |
| Option seller has unlimited risk | Option seller has limited risk, equal to the strike price multiplied by the number of shares involved |
| Option buyer has limited risk | Option buyer has limited risk |
The most important difference between call options and put options is the right they confer to the holder of the contract.
When you buy a call option, you’re buying the right to purchase shares at the strike price described in the contract. You’re hoping that the stock’s price will rise above the strike price of the option. If it does, you can buy shares at the strike price, which is lower than the current market price, and sell them immediately for a profit.
When you buy a put option, you’re buying the right to sell shares at the strike price outlined in the contract. You’re hoping for the underlying stock’s price to decrease. If the stock’s price falls below the strike price, you can sell the shares at a higher price than what those shares are trading for in the market, and earn a profit.
Options are considered “in the money” if they have intrinsic value. Call options are in the money when the strike price is below the stock price, while put options are considered in the money if the strike price is higher than the stock price.
When you sell an option, you receive a premium payment from the buyer. However, you’re promising to buy or sell shares at the strike price outlined in the contract should the buyer choose to exercise their option.
When you sell a call option, the buyer of the option has the right to buy shares from you at the strike price. If the price of the stock rises above the strike price, the call option holder can exercise their right to buy shares from you at a lower price than you would’ve sold in the open market. Theoretically, that leaves you facing unlimited risk. There is no limit to how high a stock’s price could rise and when the option holder chooses to exercise the option.
If you’ve sold a covered call, meaning you own the shares, you could be selling those shares at a heavily discounted price compared to the market and foregoing a big profit. If you’ve sold a call option on shares you do not own, you’ll be forced to buy those shares at the extremely high market price and sell them at the low strike price, incurring a theoretically unlimited loss.
On the other hand, those who put options face limited risk. When you sell a put option, you are giving the option holder the right to sell you shares at the strike price. If the stock price falls below the strike price, the buyer of the put option can exercise the contract, forcing you to buy shares at a higher price than you would have in the open market.
The lowest that a stock’s price could fall to is $0. If that happens, the option holder could exercise their option and sell shares at the strike price, leaving you with worthless securities. However, because stock prices can’t fall below $0, the maximum loss you face can be determined by the following formula:
Maximum loss for put option seller = (Strike price * Number of shares included in the contract) - Premium received
To purchase an option, the buyer pays a premium to the seller of the contract.
Options holders have the right, but not the obligation, to exercise the contract and buy or sell shares at the strike price. In the majority of cases, it may not be worth it to exercise the option, unless it's in the money.
For example, if a stock is trading at $59 and you hold a call option with a strike price of $60, you’re better off not exercising the option to purchase those shares because you can buy the same shares for a dollar less per share in the open market.
Similarly, if you hold a put option, the stock is trading at $60, and you hold a call option with a strike price of $59, you’re better off not exercising your option to sell the shares as they can fetch a better price in the open market.
Because there is no obligation to exercise an options contract, the maximum risk a buyer faces is limited to the premium they paid.
In-the-money options don’t necessarily mean profitable trades. Your option could be in the money, but you could still make a loss after paying the premium and transaction costs.
Whether you want to use a call option or a put option depends on which side of the transaction you’re on and your predictions about future price movement.
If you’re buying options, you should buy a call if you think prices will rise and buy a put if you think they will decrease. Doing this will let you buy shares at a discount or sell them at a markup, respectively.
Keep in mind that buying options is less risky than selling them. When buying, your risk is equal to the premium paid. Theoretically, options sellers face unlimited risk.
If you’re selling options, you should sell calls if you expect prices to fall and sell puts if you expect them to rise. This will let you pocket the premium without worrying about the buyer exercising the contract.
Imagine Jane wants to buy an option for XYZ, which is currently trading at $50. Jane believes that XYZ is going to increase in value, so she buys a call option with a strike price of $55. The option premium costs $125 and covers 100 shares.
If XYZ’s price rises above $55, she can exercise the option to buy 100 shares for $5,500. With the premium, she’ll have paid $5,625 for the shares in total, so she’ll earn a profit at any time XYZ’s price is above $56.25. If XYZ doesn’t rise above $55, Jane won’t exercise the option and will lose the $125 premium she paid.
If Jane believes XYZ is going to lose value, she’ll buy a put option instead. Imagine she buys a put option covering 100 shares. The option premium costs $125 and has a strike price of $45. If XYZ falls below $45, she can exercise the option. Her profit will be equal to:
((Current share price - 45) * 100) - $125)
If XYZ stays above $45, she will not exercise the option, and Jane loses just the $125 premium paid.
Investors can combine both puts and calls to create complex options strategies allowing them to profit from situations such as a stock’s price staying within a certain range.
For example, a short strangle options strategy involves selling a call option with a strike price above the current share price and selling a put option with a strike price under the current share price.
So if XYZ is trading at $50, Jane can sell a call with a $55 strike price and a put with a $45 strike price. She’ll receive the premium payment from both contracts. Neither option buyer will exercise their contracts as long as the stock’s price remains between $45 and $55. However, if the stock moves significantly in either direction, Jane could lose money when the buyer exercises the contract.
There are other complex strategies involving buying and selling calls and puts at different strike prices and in different combinations. With clever application of options, you can profit from almost any type of market movement.
Options are derivatives that let you buy or sell the right to buy or sell stocks at a set price. While buying options has limited risk, selling them can generate significant, theoretically infinite risk. Keep this in mind when choosing whether to buy or sell options and which type of options to use in your investing strategy. Also, remember that trading derivatives is riskier than trading stocks.
In general, you should exercise options when they are in the money. For put options, that happens when the stock’s price is below the option’s strike price. For call options, that happens when the stock’s price is above the strike price of the option.
When you sell call options, you make money from the premium paid. When you buy call options, you can make money if the price of the stock rises above the strike price. If that happens, you can exercise the option to buy shares below their market value. If you then sell the shares, you earn a profit.
To sell put options, you can work with an options trading platform or your brokerage to open an options account. You’ll then be able to submit a sell order for put options outlining the strike price, expiration date, and the underlying stock.
