There is an array of investment opportunities for investors in the financial markets today. Options are popular in the derivatives market. They are contracts between two parties in which grants one party the right not obligation to trade an underlying asset or security at a particular price which they agree on, or before a specific date. The simplest way to trade them is through call option and put option. The right to buy is a call option, whereas the right to sell is exercising a put option.
A trader who makes a call earns a profit when the value of the underlying asset goes up, whereas one who exercises a put option earns a profit when the price of the underlying security goes down.
Call Option
For this type of a derivative contract, you purchase the right to buy the underlying financial asset before a specific date in the future at a fixed price also known as the “strike price”. The amount you pay upfront for the contract is the “premium”. When the trader exercises the call option, the seller must sell at the strike price. All financial market instruments have option contracts such as stocks, bonds, currencies, commodities, and so on.
Put Option
It grants a buyer the right to sell an underlying asset or security by a specific date at the strike price. The buyer must pay the premium to secure the right. Once the buyer exercises the put option, the seller must buy the underlying asset at the price set.
Differences between a call and put option
- By definition, calls and puts are different where a call involves the right but not obligation to buy underlying security while a put involves the right but not obligation to sell an underlying asset.
- Investors’ expectations: In a call option, the investor earns a profit when the value of the underlying asset rises. On the other hand, in a put option, the investor makes money when the value of the underlying asset falls. The potential profit in call options is unlimited due to zero limits in mathematical restrictions, but we cannot say the same for put options.
- Analogies: Investors consider calls as a security deposit which allows them to take a product at a particular fixed price. For put options, investors think of them as insurance giving them protection against a loss in value of an underlying asset in their portfolio.
- Both the call option and put option are also In the Money or Out of the Money. However, for call options, the underlying security price is above the strike price. “Out of the money” shows that the price of the underlying asset is below the strike price of the call. The other aspect, “At the Money” suggests that the strike price and price of the underlying asset are at par. The premium amount is higher for “In the Money option” since it involves an intrinsic value. The options are vice versa for puts.
In conclusion, both call option and put option involve a lot of speculation. They are not difficult to understand once you grasp the basic idea.
