Call and put options are standard derivatives or contracts granting the buyer certain rights. Importantly, these rights do not require buying or selling the underlying asset at a pre-decided price within a specific timeframe. Read on to learn more about them.
With a call option, you get the right (but no obligation) to purchase a stock at a pre-specific price (strike price), before a specified expiration date.
Imagine Mr. Kapoor, an investor in Mumbai, has been closely monitoring the stock of XYZ Ltd., an Indian tech company. He believes that the stock's price is poised to rise in the near future due to an anticipated product launch. To capitalize on this expected price increase, Mr. Kapoor decided to purchase a call option on XYZ Ltd.
Here's how it works:
Selection of the Call Option: Mr. Kapoor selects a specific call option contract for XYZ Ltd. This contract includes details such as the strike price, expiration date, and premium (the cost of the option).
Payment of Premium: To secure the call option, Mr. Kapoor pays the premium to the option seller (also known as the option writer).
Rights to Buy: By purchasing the call option, Mr. Kapoor acquires the right (but not the obligation) to buy a specified number of XYZ Ltd. shares at the predetermined strike price before the expiration date. Let's say the strike price is Rs. 1,000 per share, with an expiration date is one month from the purchase date.
Market Movement: As Mr. Kapoor predicted the stock price of XYZ Ltd. rose substantially in the weeks following his call option purchase, reaching Rs. 1,200 per share.
Exercising the Option: With the stock price now higher than the strike price, Mr. Kapoor decides to exercise his call option. He buys the agreed-upon number of XYZ Ltd. shares at the strike price of Rs. 1,000 per share.
Profit Realization: After acquiring the shares at the strike price, Mr. Kapoor has two options: He can either hold onto the shares or sell them in the open market. In this case, he chooses to sell the shares at the prevailing market price of Rs. 1,200 per share, making a profit of Rs. 200 per share (Rs.1,200 - Rs.1,000).
Final Gains: Mr. Kapoor's total profit from the call option is the difference between the market and strike prices, multiplied by the number of shares. If he bought 100 shares through the call option, his profit would be Rs.20,000 (Rs. 200 per share X 100 shares).
In this scenario, Mr. Kapoor effectively leveraged a call option to capitalize on his bullish outlook on XYZ Ltd.'s stock. He benefited from the price increase without initially purchasing the shares at the market price, thereby magnifying his gains in the Indian stock market.
With a put option you have the right, without any obligation, to sell a particular asset, frequently a stock, at a predetermined strike price before a specified expiration date. Essentially, put options provide investors with a strategic advantage, enabling them to profit from a potential decline in the stock's market price. When the market price goes below the strike price, the holder can sell the asset at the higher strike price, thus reaping a gain.
Let's understand the working of a put option. Raj is an astute investor in the Indian stock market. He closely follows the pharmaceutical sector and has been tracking the stock of ABC Pharmaceuticals, which has recently experienced some turbulence due to regulatory concerns.
One day, Raj notices that ABC Pharmaceuticals is trading at Rs. 1,200 per share, but he has a gut feeling that the stock might face further declines in the coming weeks due to an impending regulatory announcement.
Raj decides to purchase a put option contract for ABC Pharmaceuticals to protect himself from potential losses. He buys a put option with the following details:
Here's how Raj's put option works:
Bearish Outlook: Raj expects the stock price of ABC Pharmaceuticals to drop shortly, which is why he chooses to buy a put option. This aligns with his bearish market outlook.
Contract Terms: The strike price is set at Rs. 1,100, which means that Raj has the right, but not the obligation, to sell ABC Pharmaceuticals shares for Rs. 1,100 each, regardless of the current market price, until the option's expiration date.
Premium Paid: Raj pays a premium of Rs. 50 per share for the put option contract. This is the cost of acquiring the right to sell ABC Pharmaceuticals shares at Rs. 1,100.
Scenario 1 - Stock Price Falls: If, before the option's expiration date, the stock price of ABC Pharmaceuticals indeed falls to Rs. 1,000 per share, Raj's put option becomes valuable. He can buy shares in the open market at the lower market price of Rs. 1,000 and then sell them for the higher strike price of Rs. 1,100, realizing a profit of Rs. 100 per share (Rs. 1,100 - Rs. 1,000 - Rs. 50 premium paid).
Scenario 2 - Stock Price Rises: If the stock price remains above Rs. 1,100 or even increases, Raj is not obligated to exercise the put option. In this case, he would let the option expire, incurring a loss limited to the premium of Rs. 50 per share he paid to acquire the option.
By using a put option, Raj has effectively protected himself from potential losses in case the stock price of ABC Pharmaceuticals does indeed decline. This financial instrument empowers him to profit from his bearish market prediction, all while limiting his risk to the premium he paid for the option.
Here are the differences between call and put options on various aspects:
Expects the underlying asset's price to rise.
Expects the underlying asset's price to fall.
Right to buy/sell
The right to buy the asset at the strike price.
The right to sell the asset at the strike price.
Obligation to Exercise
No obligation to buy the asset.
No obligation to sell the asset.
Risk and Reward
Limited risk (premium paid) with unlimited reward potential.
Limited risk (premium paid) with limited reward potential.
Preferred in bullish markets.
Preferred in bearish markets.
Value increases as the underlying asset's price rises.
Value increases as the underlying asset's price falls.
Profits realized when the asset's price exceeds the strike price.
Profits realized when the asset's price falls below the strike price.
|Aspect||Call Option||Put Option|
|Profit Direction||Expects the underlying asset's price to rise.||Expects the underlying asset's price to fall.|
|Right to buy/sell||The right to buy the asset at the strike price.||The right to sell the asset at the strike price.|
|Obligation to Exercise||No obligation to buy the asset.||No obligation to sell the asset.|
|Risk and Reward||Limited risk (premium paid) with unlimited reward potential.||Limited risk (premium paid) with limited reward potential.|
|Market Outlook||Preferred in bullish markets.||Preferred in bearish markets.|
|Market Behavior||Value increases as the underlying asset's price rises.||Value increases as the underlying asset's price falls.|
|Profit Timing||Profits realized when the asset's price exceeds the strike price.||Profits realized when the asset's price falls below the strike price.|
Call option and put option hold a place of significance in the investor's toolkit, allowing for a nuanced approach to market dynamics. Mastering these essential derivatives equips individuals with the flexibility to adapt to changing circumstances, ensuring they can navigate the financial landscape with confidence and agility.
A call option grants the holder the privilege to purchase an underlying asset or contract at a predetermined price in the future, with the price being determined today. Conversely, a put option bestows the holder with the right to sell an underlying asset or contract at a fixed price in the future, with this price being established today.
Regarding profitability, call options offer unlimited profit potential since there is no upper limit on a stock's price. In contrast, put options have restricted profit potential as the price of a stock cannot fall below zero.
If there is a greater demand for put options compared to call options, it suggests a looming bearish market sentiment. Conversely, when call options are in higher demand than put options, it hints at a potential bullish market outlook in the near future.
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