Call and Put Options: Meaning, Differences and Risks Involved

Call and Put Options for Beginners

What Is a Call Option?

A call option is a typical contract that grants a buyer the right to purchase an asset. Thus, buyers have the privilege of purchasing a particular security, such as a stock, at a certain price. It comes with an expiry date, which means your profit and loss will be settled on that day based on the difference in the stock’s price.

Call options can be bought and sold on numerous securities, such as currencies, swaps, ETFs, etc. In fact, the investors who purchase a call option aren't obligated to purchase and exercise the underlying asset at the strike price.

Formula of Call Option Payoff:

Payoff per unit = max (0, Spot Price - Strike Price)

Profit or Loss per unit = Payoff - Premium Paid

Break-even = Strike Price + Premium Paid

Example of Call Option:

Suppose a stock is trading at ₹500. An investor can purchase a call option of strike price ₹500 at a ₹20 premium.

Scenario 1: If the stock price rises to ₹600, then his profit will be:

Profit = ₹600 - ₹500 - premium paid

= ₹100 - ₹20 = ₹80

Scenario 2: If the stock price falls below ₹500, the investor will make a loss of ₹20(the premium paid. His breakeven point is ₹520.)

What Is a Put Option?

The put option provides a buyer with the right to sell the underlying asset at the specified strike price. However, there is no obligation for the buyer to do the same. But the ‘ put option' seller has to buy the asset when the put buyer starts exercising their option.

The majority of investors purchase ‘puts’ only when they’re determined that the underlying asset’s price will decrease. Likewise, they sell puts once they know that the underlying assets will increase.

Formula for Put Option Payoff:

Payoff per unit = max (0, Strike Price - Spot Price)

Profit or Loss per unit = Payoff - Premium Paid

Breakeven = Strike Price - Premium Paid

Example of Put Option:

Strike price: ₹1,000

Spot price at expiry: ₹900

Premium paid: ₹20

Payoff= max (0, ₹1,000 - ₹900)= ₹100

Net profit = ₹100 - ₹20 = ₹80 per unit

Breakeven = ₹1000 - ₹20 = ₹980

The call and put options explained above with formula and example aim at making option trading easier for beginners.
 

What is the Difference Between Call and Put Options?

A comparison table differentiating puts and calls for beginners will give them a clear idea of how expectations and real-world observations differ. The table below shows some of the major differences between call and put options:

How to Calculate Call Option Payoffs?

In the call and put option NSE, the call option payoff refers to the profit or loss made by an option buyer or seller. There are three distinctive variables such as expiry date, strike price, and premium, for evaluating call options. Furthermore, these variables are used for calculating the payoffs which are generated from Call options.

Call option payoffs can be classified into two cases:

●    Payoffs for Call Option Buyers

Let’s assume that you purchase a call option for a company for a premium of Rs. 100. The strike price of the option is Rs. 500 and has an expiration date of 30th November. Even if the company’s stock price reaches Rs. 600, you’re likely to break on your investment.

And if any increase is above the said amount, it is considered a profit. Therefore the payoff value becomes unlimited when the company’s share price increases.

The payoff and profit amount are calculated by using the following formulas:

●    Payoff = Spot Price - Strike Price
●    Profit = Payoff - Premium Paid

●    Payoff for Call Option Sellers

Please note that calculating payoff for the call option in the case of a seller is not quite different from the buyers. If you sell a particular options contract with a similar expiry date and strike price, then you can gain when the price declines. And as per the character of your call option, your losses could be limited or unlimited.

Also, your losses are likely to be unlimited whenever you are forced to purchase the underlying stock at spot prices. However, in this case, your sole income is limited to the premium that is collected after the option contract expires.

The payoffs and profit amount for sellers are calculated using the following formulas:

●    Payoff = Spot Price - Strike Price
●    Profit = Payoff + Premium Paid

How to Calculate Put Option Payoffs?

The total profit or loss of a put option trade entirely depends on two distinctive things:

●    Firstly, the things you are likely to receive while exercising the option
●    Secondly, the amount paid for the option in the beginning.

Please note that the first component is equivalent to the difference between the strike price and the underlying price. When the underlying price gets lower in comparison to the strike price, the higher your cash gain becomes during expiration.

●    Payoffs for Put Option Buyers

A put option provides the right to the buyer to sell the underlying asset at the specified strike price. In fact, the profit or loss made by the buyer on the option completely depends on the spot price of the underlying.
But if the spot price is below the strike price during expiry, the buyer can make a significant profit. In a nutshell, the lower the spot price becomes, the greater profit the buyer makes. But if the underlying spot price is greater than the strike price, then the buyer enables his option to expire.

This is typically done by the buyer while keeping his option unexercised. So, in this case, the loss of the buyer is the premium paid for buying the put option.

●    Payoff for Put Option Sellers

When it comes to selling the put option, the seller of the option charges a premium amount. And the profit or loss made by the buyer on the put option entirely depends on the spot price of the underlying.
So whatever profit the buyer makes is typically the loss of the seller. And if the spot price is lower than the strike price during expiry, the put option will be exercised on the seller. But if it's vice versa, the buyer enables his option un-exercised while the seller keeps the premium amount.

Risk vs Reward – Call Option and Put Option

Here, we have compared and listed the risks and rewards of both call and put options:

Conclusion

Call and put options are powerful financial tools when used correctly, enabling traders to speculate, hedge, and diversify strategies. However, beginners should approach them cautiously, build a strong conceptual foundation, and practise disciplined risk management before actively trading.

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What are the Risks of Trading Call Options?

The common risks of trading call options are opportunity loss in covered calls, unrestricted loss in naked calls, market volatility and margin requirements in naked calls. Understanding the risks of call and put options in detail might lower your chances of losing money when your market predictions are right.

Some risks of trading call options are:

1.Unrestricted Loss in Naked Calls

It is vital for investors selling a call option to know that losses might be unlimited. There are a few instances when stock prices increase significantly above the strike price. In such a scenario, you have to buy it at a higher market price before selling to an option holder at a lower strike price. This can lead to losses.

2. Opportunity Lost in Covered Calls

Though there is less risk in a covered call, you might miss out on gains if the stock price increases drastically above the strike price. Even in such situations, you will have to sell the stock at the strike price instead of the market price. You might miss out on high gains.

3. Market Volatility

When the market is volatile, selling options can be more risky. You might have to face huge losses if the stock price moves fast in one direction. If you are wondering “what is market volatility?”, it refers to how much an asset price fluctuates over a given period.

High volatility reflects more uncertainty. When trading options, it can increase the premium you receive. But if the market moves against you, you might incur potential losses. 

4. Naked Calls Require Margin

The margin requirement for naked calls ensures that there are sufficient funds in your account so that you can pay for potential losses when the stock price increases. The minimum margin requirement will not only tie up your capital but might also increase the chances of losses exceeding your account margin.

What are the Risks of Trading Put Options?

The common risks of trading put options are premium loss, limited lifespan and market timing risk. Understanding the risks of call and put options in detail might lower your chances of losing money when your market predictions are right.

Some of the risks of trading put options are:

1. Premium Loss

The investor has to pay a premium when buying the put option, which is non-refundable. There are some instances when the market does not move as expected by the investor. Such being the situation, he might lose the premium even if he does not exercise the option.

2. Limited Lifespan

The profit opportunity when trading put options is time-bound as they come with expiration dates. You might lose the premium amount, and the put option might become useless if the price of the stock does not fall by expiration.

3. Risk of Market Timing

Sometimes, even investors with adequate market knowledge might find it challenging to predict when the price of an underlying asset will fall. They might miss opportunities if they estimate the wrong timing, as the option might expire before reaching the expected price drop.