Call and put options are derivative investments, meaning their price movements are based on the price movements of another financial product. The financial product a derivative is based on is often called the "under
lying." Here we'll cover what these options mean and how traders and buyers use the terms.What Are Call and Put Options?
Options can be defined as contracts that give a buyer the right to buy or sell the underlying asset, or the security on which a derivative contract is based, by a set expiration date at a specific price.
This specific price is often referred to as the "strike price." It's the amount at which a derivative contract can be bought or sold.
- A call option is bought if the trader expects the price of the underlying to rise within a certain time frame.
- A put option is bought if the trader expects the price of the underlying to fall within a certain time frame.
Puts and calls can also be written and sold to other traders. This generates income but gives up certain rights to the buyer of the option.1
How Call Options Work
For U.S.-style options, a call is an options contract that gives the buyer the right to buy the underlying asset at a set price at any time up to the expiration date.2
Buyers of European-style options may exercise the option— to buy the underlying—only on the expiration date. Options expirations vary and can be short-term or long-term.
With call options, the strike price represents the predetermined price at which a call buyer can buy the underlying asset. For example, the buyer of a stock call option with a strike price of $10 can use the option to buy that stock at $10 before the option expires.1
It is only worthwhile for the call buyer to exercise their option (and require the call writer/seller to sell them the stock at the strike price) if the current price of the underlying is above the strike price. For example, if the stock is trading at $9 on the stock market, it is not worthwhile for the call option buyer to exercise their option to buy the stock at $10 because they can buy it for a lower price on the market.
What the Call Buyer Gets
The call buyer has the right to buy a stock at the strike price for a set amount of time. For that right, the call buyer pays a premium. If the price of the underlying moves above the strike price, the option will be worth money (it will have intrinsic value). The buyer can sell the option for a profit (this is what many call buyers do) or exercise the option (receive the shares from the person who wrote the option).3
What the Call Seller Gets
The call writer/seller receives the premium. Writing call options is a way to generate income. However, the income from writing a call option is limited to the premium, while a call buyer has theoretically unlimited profit potential.4
Calculating the Call Option's Cost
One stock call option contract actually represents 100 shares of the underlying stock. Stock call prices are typically quoted per share. Therefore, to calculate how much it will cost you to buy a contract, take the price of the option and multiply it by 100.4
Call options can be in, at, or out of the money:
- In the money means the underlying asset price is above the call strike price.5
- Out of the money means the underlying price is below the strike price.
- At the money means the underlying price and the strike price are the same.
You can buy a call in any of those three phases. However, you will pay a larger premium for an option that is in the money because it already has intrinsic value.
How Put Options Work
Put options are the opposite of call options. For U.S.-style options, a put options contract gives the buyer the right to sell the underlying asset at a set price at any time up to the expiration date.2 Buyers of European-style options may exercise the option—sell the underlying—only on the expiration date.
Here, the strike price is the predetermined price at which a put buyer can sell the underlying asset.1 For example, the buyer of a stock put option with a strike price of $10 can use the option to sell that stock at $10 before the option expires.
It is only worthwhile for the put buyer to exercise their option (and require the put writer/seller to buy the stock from them at the strike price) if the current price of the underlying is below the strike price. For example, if the stock is trading at $11 on the stock market, it is not worthwhile for the put option buyer to exercise their option to sell the stock at $10 because they can sell it for a higher price on the market.
What the Put Buyer Gets
The put buyer has the right to sell a stock at the strike price for a set amount of time. For that right, the put buyer pays a premium. If the price of the underlying moves below the strike price, the option will be worth money (it will have intrinsic value). The buyer can sell the option for a profit (this is what many put buyers do) or exercise the option (sell the shares).3
What the Put Seller Gets
The put seller, or writer, receives the premium. Writing put options is a way to generate income. However, the income from writing a put option is limited to the premium, while a put buyer can continue to maximize profit until the stock goes to zero.4
Calculating the Put Option's Cost
Put contracts represent 100 shares of the underlying stock, just like call option contracts. To find the price of the contract, multiply the underlying's share price by 100.
Put options can be in, at, or out of the money, just like call options:
- In the money means the underlying asset price is below the put strike price.5
- Out of the money means the underlying price is above the strike price.
- At the money means the underlying price and the strike price are the same.
Just as with a call option, you can buy a put option in any of those three phases, and buyers will pay a larger premium when the option is in the money because it already has intrinsic value.
Key Takeaways
- A call option is bought if the trader expects the price of the underlying to rise within a certain time frame.
- A put option is bought if the trader expects the price of the underlying to fall within a certain time frame.
- The strike price is the set price that a put or call option can be bought or sold.
- Both call and put option contracts represent 100 shares of the underlying stock.