Explanation of Put and Call Option

Explanation of PUT and CALL OPTION with Useful Examples

In this explanation of put and call option, you will learn about the basic definition of put and call option, the similarities of the two, a couple of examples, as well as some illustration on the applications.

To begin with, let’s look at the common characteristics of both put and call option:

* Options have predefined life-span, i.e. they undergo an erosion of value (termed as time decay) as it approaches expiration.

* All options are pegged to a pre-specified prices which is the strike prices (or exercise prices).

* The value (premium) of options is made-up of 3 main components, namely: a. Intrinsic Value, b. Implied Volatility and c. Time Decay

* As a holder (buyer) of an option, you are given the right (but not the obligation) to buy or sell the underlying instrument. To enjoy the privilege, you have to pay a premium to own the option.

* Each option is pegged to 100 shares if equity is the underlying.

* The seller of the option is not required to own the underlying when the option is written.
 

Explanation of Put and Call Option: Definitions

Call Option

Owing a call option gives the holder a right (but not obligation) to BUY the underlying at a pre-specified strike price and within a pre-determined time (expiration date).

Put Option

Owing a put option gives the holder a right (but not obligation) to SELL the underlying at a pre-specified strike price and within a pre-determined time (expiration date).

To help you to understand further in the explanation of put and call option, let’s start with the purchase of call option.

Explanation of Call Option:

Buying a call option is very similar to buying a stock and is perhaps the simplest to understand.

For example, it is the month of January, and you believe that Apple Computer’s share is going up, which is trading at say, USD 76/share. Instead of buying the share directly, you have decided to purchase the option with an exercise price of USD80. The cost to you in owning the option is say, USD1.5 for an option with 1 month (Feb) to expiration. If you believe that Apple Computer can rise over USD 80 (as a matter of fact, over USD 81.5 to include the cost of your option) within the next one month, you may choose to purchase this Feb option given its low premium level.

There is however, a certain degree of risk here as you only have 1 month window for the stock to perform well and cross the hurdle of USD80, notwithstanding the fact that options that are nearer to the expiration have faster time decay.

Alternatively, if you are of the view that Apple Computer is going up, but prefers to take the advantage of its long term trend to be on the safe side and buy the 6 months (Jul) to expiration option which costs USD8, with the hope that Apple Computer shares will rise to USD80 (at least USD 88 at expiration to offset your option premium) or more. Of course, Apple Computer could possibly moves up a lot within a short period and you could closed out your position and net the profit.

With the longer term option, you have a wider window for the underlying stock to perform but you have to also fork out a larger premium to pay for your option.

In either cases, you have to be right about the upward movement of Apple Computer and within the time frame you predicted, because if you own the Apple Computer stock and it stays totally unchanged (for discussion purpose) within the option period, you will have to part with the option premium that you have paid. Whereas, if you were to own the underlying stock, you are still at break-even level, which is a better outcome as compared to owning the call option and even better outcome for the call option seller since he has pocketed the premium.

Conversely, if you are the seller of the option, your aim is to let the option expire worthless. In this case, you may want to choose a stock which is on a down trend – for example, major airlines that have been under stiff competitions due to entrance of budget airlines and rising oil prices. You will sell the call option on retracement.

You can sell the call option regardless of whether you own the underlying. However, it is generally viewed as a more conservative approach if you were to own the underlying stock. If you owned the underlying and sell a call option, the combination is termed as covered call. The term “covered” means that should the call options that you have written be in the money, and the buyer wanted to buy the underlying shares at the strike price, you are “covered” from the fact that you already own the underlying stock as compared to someone who wrote (i.e. sell) the option without owning the underlying and could potentially suffer a huge loss, especially if the position is over-leveraged and the movement of the stock has moved strongly against his position.

Explanation of Put Option:

Conversely, if you choose instead to write put option, again using Apple Computer (at USD 76, Jan) as an example, you can choose to write the Febuary USD75 put option at say, USD3 per contract. This is done with the view that Apple Computer will move up in value and the put option expire worthless, or you might not even mine to own Apple Computer when it is assigned to you if it moves down to around USD75 level since you think that it is a quality stock.

If your account is well financed and you wrote put option with the ready stance to own the underlying, it is a cash secured put option position. Your best scenario will be for the put option to expire worthless and you pocket the premium. Your average scenario will be the stock is assigned to you at USD75, and is currently trading in the market at say, USD74.00. You will still be okay since you have collected USD3 in advance and the net cost of the stock to you is USD72 (75 – 3). In another words, as long as Apple Computer stays above USD72, you will be fine. You worst case scenario will be the stock position move adversely downwards, well below the 72 level and you haven’t already gotten out of your position.

The explanation of put and call option will not be complete without mentioning the payout diagram of writing a put option is similar to the covered call, and has the following advantages – you only pay for one round trip brokerage commission and affected by one spread, as compared to a covered call position where you have to pay for two round trip commissions (both stock and option) and two spreads, assuming you are initiating new positions. However, if, for example, you have already own the underlying stock for a while and it has been trending up till a level which you feel it is moving sideways and to generate better returns to your portfolio, you decided to write call option on your stock holdings, it may make sense and the additional commission and spread are therefore less applicable here.

When you buy a put, you are of the view that the underlying is moving downwards. If you simply make the purchase of the put without owning the underlying, you are of the view that the underlying is going down and by purchasing the put, you maximum loss is the premium you have paid and your gain can be substantial depending on the downward movement of the underlying if your view is correct. If you already own the underlying and for reason of maintain a balance portfolio, buying the put option at an appropriate time will help to cushion the effect of the fall in the price of the underlying.

In general, an option nearer to expiration is advantages to the seller as the option decays faster nearer to its expiration date. The overriding factor is the movement of the underlying stock.

Explanation of Put and Call Option:  In conclusion, you have to know the characteristics of both put and call options and use that knowledge to your advantage. Option is a leveraged product, and is therefore like a double edged sword which can be of tremendous disadvantage if things move against you and conversely of great advantage to you if things are going your way. Also, options are closely linked to the underlying stock and in the final analysis, you have to be right about the direction of the underlying within a certain stipulated time for your option trade to be successful.

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