Call and Put Option: Meaning, Types, Examples, Differences

Options are the two derivatives contracts traded on the stock exchanges (NSE, BSE), Which is a contract whose value is derived from another asset known as underlying. These options are classified as stock options and index options, these option contracts are again divided into two types put option and Call option. An Option contract gives the right, but not an obligation, to buy or sell the underlying on or before a predetermined price within a specified period. While the buyer of the option pays the premium and buys the right, and while seller of the option receives the premium with the obligation to sell or buy the underlying asset if the buyer exercises his right.

Call Options: Provides the right to buy the underlying asset.

Put Options: Provide the right to sell the underlying asset.

These options are mostly used for hedging, speculation, and Arbitrage purposes offering flexibility and leverage to investors.

What is a Call Option?

A call option is a contract with a fixed expiry date, which gives the holder of right to purchase the underlying asset at a specified strike price within a set timeframe. The call option price increases if the underlying asset increases and decreases when the underlying asset decreases.

Example
An investor buys a call option for Stock XYZ with a strike price of ₹100, expiring in one month, for a premium of ₹5. It rises to ₹120 the investor can exercise the option to buy at ₹100, realizing a profit of ₹15 per share (₹120 market price - ₹100 strike price - ₹5 premium). 

If it remains below ₹100, the option expires worthless, and the investor loses the ₹5 premium paid.

What is a Put Option?

A put option grants the holder the right to sell the underlying asset at a specified strike price within a set timeframe. It Benefits the Buyer: Buyers profit when the asset's market price falls below the strike price, enabling them to sell at a higher price than the market value.

Example
An investor buys a put option for Stock XYZ with a strike price of ₹50, expiring in one month, for a premium of ₹3. If Stock XYS declines to ₹40, the investor can exercise the option to sell at ₹50, realizing a profit of ₹47 per share (₹50 strike price - ₹40 market price - ₹3 premium). 

If Stock ABC remains above ₹50, the option expires worthless, and the investor loses the ₹3 premium paid.

Key Differences Between Call and Put Options

How Does a Call Option Work?

The call option works when the buyers pay the premium for the right to purchase the asset at the strike price, while sellers receive a premium and assume the obligation to sell the asset at the strike price if the buyer exercises the option.

Profits and Losses

• The buyer gets the profit if the asset's price exceeds the strike price plus the premium paid while the seller gets the profit if the asset's price remains below the strike price, allowing the option to expire worthless.

How Does a Put Option Work?

Put option works where the buyers pay the premium for the right to sell the asset at the strike price where sellers receive a premium and assume the obligation to buy the asset at the strike price if the buyer exercises the option.

Profits and Losses

• The buyer gets the Profit if the asset's price falls below the strike price minus the premium paid while, the seller gets the profit if the asset's price remains above the strike price, allowing the option to expire worthless.

Types of Strike Prices for Call & Put Options

The strike price is a fundamental concept in options trading also known as the exercise price. Which is the fixed price specified in the option contract. Where the buyer and seller agree to buy or sell the underlying asset upon exercising the option. It represents the pre-determined price at which the option contracts are traded. This fixed price is fixed by the exchange at the time of inception of the options contracts and remains the same until the contract expires.

The relationship between the strike price and the spot price is a vital factor that determines the moneyness of an option, it has been classified into three different.

In-the-Money (ITM):

When the strike price is near to the current market price is considered as an “in-the-money” contract.

• Call Option: For the call option the Strike price is below the current market price of the underlying asset and is considered as ITM.
• Put Option: For the put option, the strike price is above the current market price of the underlying asset and is considered as ITM.

At-the-Money (ATM):

When the strike price and the current market price are near it is to be considered as the “At-The-Money” contract

• Call Option: For the call option the Strike price is near the current market price of the underlying asset and is considered as ITM.
• Put Option: For the put option the strike price is near the current market price of the underlying asset and is considered as ITM.

Out-of-the-Money (OTM)

When the strike price and the current market price are near it is to be considered as the “On-The-Money” contract.

• Call Option: For the call option the Strike price is above the current market price of the underlying asset and is considered as ITM.
• Put Option: For the put option, the strike price is below the current market price of the underlying asset and is considered as ITM.

Let’s understand the moneyness of Option contracts visually

How to Buy Call option?

To buy a call option, you are getting the right to buy an underlying asset, such as a stock or Index before a certain expiration date. The process of buying a call option begins by selecting an asset, and then picking an expiration date and a strike price. You’ll pay a premium for the option, which varies based on the stock’s current price, strike price, and the time until expiration. 

If the stock price rises above the strike price, your option gains value and you can either sell it for a profit or you can wait till expiry.

How to Sell Call Option?

when you sell a call option, you are getting an obligation to sell the underlying asset. In most cases, sellers own the underlying assets like stocks and indices. which provides some protection in case the option is exercised. You receive the premium upfront from selling the option, and your goal is to keep that premium as profit, especially if the stock price stays below the strike price. 

The call options carry the risk of selling the asset at the strike price, which can result in missed gains if the underlying asset price rises significantly.

How to Buy Put option?

When you are buying a put option involves purchasing the right to sell an underlying asset at a predetermined strike price before the option’s expiration date. The process of buying a Put option begins by selecting an asset, and then picking an expiration date and a strike price. 

You’ll pay a premium for the option, which varies based on the stock’s current price, strike price, and the time until expiration. If the stock price falls below the strike price, your option gains value and you can either sell it for a profit or you can wait till expiry.

How to Sell Put option?

When selling a put option, you are agreeing to buy the underlying asset if the option is exercised by the buyer. This type of strategy is often used if you believe the asset’s price will stay above the strike price. Sellers of puts receive the premium upfront and hope the option expires worthless which allows them to keep the premium as profit. 

However, selling puts comes with the risk of having to buy the asset at the strike price if it falls below that value.

How to calculate option Pay Off’s?

Call Option Payoff

A Call option allows the holder to buy the underlying asset at the pre-agreed strike price. The potential payoff of a call option is tied directly to how the underlying asset's price compares to the strike price at the time of expiration.

The formula for Call Option Payoff:  

Call Payoff = max (0, Spot Price−Strike Price)

Where:

Spot Price: The market price of the underlying asset is trading.

Strike Price: The price at which the call holder can buy the underlying asset.

Example: Call Option Payoff

Strike Price: 1,500

Spot Price at Expiration: ₹1,700

The payoff will be, Call Payoff = max (0,1700−1500)  = 200

Since the spot price of 1700 is higher than the strike price of 1500, the call option holder can make a profit of 200 by exercising the option to buy the stock at 1500 and sell it at the market price of 1,700.

If the spot price had fallen to 1400, the payoff would have been zero, as the option holder would not have exercised the option because it would be cheaper to buy the asset in the open market.

Profit Potential

• The profit potential for a call option is unlimited. As the price of the underlying asset increases, the value of the call option increases wisely.

Put Option Payoff

A Put option allows the holder to sell the underlying asset at the agreed strike price. The payoff for a put option increases as the price of the underlying asset decreases.

Formula for Put Option Payoff : 

Put Payoff = max (0, Strike Price−Spot Price)

Where:

Spot Price: The market price of the underlying asset at the time of expiry.

Strike Price: The price at which the PUT holder can sell the underlying asset.

Example : Put Option Payoff

Strike Price: ₹1,500

Spot Price at Expiration: ₹1,300

The payoff will be, Put Payoff = max (0,1500 − 1300) =₹200

Since the spot price of 1300 is lower than the strike price of 1500, the put option holder can make a profit of 200 by exercising the option to sell the asset at 1500 and buy it back at the market price of 1300.

If the spot price had been 1600, the payoff would have been zero, as the option holder would not have exercised the option because it would be more profitable to sell the asset in the open market.

Profit Potential:

• Limited Profit, the maximum payoff for a put option is limited to the strike price if the asset price goes to zero. This is because the lowest value of a stock or asset can have been zero.

Key Factors Influencing Payoffs

Strike Price and Spot Price

• The key to understanding option payoffs is the relationship between the strike price and the spot price of the asset at expiration.

Premium

• While the strike price determines the payoff, premiums and the price paid to buy the option are crucial. The premium paid for the option must be factored into the overall profit/loss calculation.

Time to Expiry

• The more time an option has before expiry, the greater the chance it has of becoming profitable. Options lose value over time, this is called time decay.

Volatility

• The volatility of the underlying asset can also be impacted on the option's value. High volatility increases the potential for large movements in the price, which can affect the payoff.

Conclusion:

In conclusion, we can consider options contracts, such as call and put options, provides valuable tools for hedging, speculation, and arbitrage. These financial instruments are derived from the underlying asset and offer flexibility and leverage to manage risk or capitalize on potential price movements in the market. A call option grants the right to buy the asset, while a put option grants the right to sell, each with its own unique characteristics and strategic applications. 

By understanding the key differences between these options, the concept of moneyness, and the various factors influencing their value, investors can make informed decisions to enhance their portfolio management. However, options trading comes with its own set of risks, including the potential for loss limited to the premium paid for buyers and the obligation for sellers to fulfil the contract terms if exercised. Ultimately, options are powerful tools in a trader’s arsenal, but they require careful analysis and strategy to maximize their benefits.

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