A call option
is a contract by two parties to exchange a stock at a ‘strike price’ by a predetermined date. • The buyer can choose to buy the share or not
- The seller has an obligation to sell if the buyer wants to buy
- Buyer of the option must pay a premium to the seller, regardless of whether the option is exercised
A put option
is a contract by two parties to exchange a stock at a strike price by a pre-determined date
- The buyer pf the ‘put’ has a right, but not obligation to sell
- Seller of the ‘put’ has obligation to buy if the buyer wants to buy
- Buyer of the option must pay a premium to the seller, regardless of whether the option is exercised
These two options can sound very similar, and although they are, there is a main difference. This difference is in the belief of the buyer. ‘Call options’ are bought in the belief that the stock will be worth a higher price in the future. In contrast, ‘put options’ are bought if they believe the stock will be worth less. The premium is just an amount given to the owner of the stock to reserve the stock for them and potentially sell them the stock at a loss.
For example, take a stock currently worth $10
(all figures are randomly chosen for this example)
Someone may wish to purchase a ‘call option’
• Strike price is $12 • Period is 3 months
• Premium is 50c
At the same time, someone else purchases a ‘put option’ of the same stock
• Strike price is $8
• Period is 3 months
• Premium is 50c
2 months later the stock is now worth $15, this is good for the person who purchased the call option. The person who purchased the call option can choose to purchase the stock at the agreed price of $12, making $2.50 per option (profit – premium). However, the person who purchased the put option can choose to leave the option open. If the price continues to rise, then the person who purchased the put option can simply let it expire, and then they are only at a 50c loss.
Essentially a call and put option are contracts in which the buyer has the option to purchase or sell a stock at a specific price for a premium.
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