Call Option vs Put Option – The terminologies of Call and Put are associated with Option contracts. An option contract is a form of a contract or a provision which allows the option holder the right but not an obligation to execute a specific transaction with counterparty (option issuer or option writer) as per the terms and conditions stated. An option is considered as a derivative contract since its value is derived from an underlying security.
Let us consider a simple example. The shares of Corporation ‘PQR’ are currently trading at $50. Mr. A predicts the price to rise after 2 months to $55. On the other hand, Mr ‘B’ is of the opinion that prices will fall to $46 or lower. As both parties have an opposite view and there is a financial obligation involved, they can enter into an option contract whereby Mr ‘A’ will hold the call option for purchasing the share if it rises to $55 or more at the pre-decided price which in this case is $55 after 2 months. On the other hand, Mr ‘B’ is holding a Put option since price is expected to fall below a threshold ($46 in this case).
Generally, options are associated with equity stocks as the underlying but it could be other instruments such as Futures, Commodities, Bonds or even an index. In case of bonds, a put option on is a provision which allows the bond holder the right to force the issuer for paying back the principal amount of the bond. A call option is the opposite whereby the issuer can redeem all of the outstanding bonds.
In this article, we look at the key differences between Call Options vs Put Options –
- Call Options vs Put Options Infographics
- What is Call Option?
- What is Put Option?
- Key Differences – Call Options vs Put Options
- Call Options vs Put Options (Comparison Table)
- Conclusion – Call Option vs Put Option
Also, have a look at Option Strategies
Call Options vs Put Options Infographics
Let us look at some of the basic differences between Call Option vs Put Option in a nutshell:
What is Call Option?
As discussed above, a call option is anticipation in rise of prices above the current or a certain level. The contract will have to be executed at the strike price if it is useful to the call option holder on or before the expiry date. For e.g. Mr ‘A’ will purchase 250 shares at $20 of Adlabs Limited (assuming this is the current market price) after 90 days (3 months) from the current date from the counterparty (Mr ‘B’). To secure such a deal, Mr ‘A’ has to pay a premium say $500 for the same. Post these 3 months, if the price of these shares increases to say $23 then Mr ‘A’ can purchase shares from the counterparty at $20 by exercising the right and Mr ‘B’ is obligated to pay the same. If the price falls to less than $20, then Mr. ‘A’ will not purchase the same from Mr. ‘B’ allowing the option to expire worthless. This is because if shares are available from the market at $18, it would be a loss to execute the option at $20. However, the option holder (Mr A) will have to forego the premium amount paid ($500).
What is Put Option?
The Put option will be in favor of the prices falling down over a given period of time as opposed to the call option. For e.g. Mr ‘A’ purchases a put option and enters into a contract with Mr. B. (Seller) for selling of 250 shares for $20 of Adlabs Limited (prevailing price in the market) after 3 months from the date. For securing the deal, Mr ‘A’ pays a premium of $500. Before the expiry of the term, the share price of the firm falls to $18 per share, enabling Mr ‘A’ to purchase the shares from the stock market and then sell them to Mr. ‘B’ at $20. However, if the share price rises to $22, then it will be of no use to purchase it at a higher rate and sell at a lower rate making it an overall loss.
It is to be noted that there are certain similarities in both Call Option vs Put Option:
- It is a common agreement between 2 counterparties having opposite views on the financial market
- Time is a critical factor of the contract which means the option has to be exercised on or before the expiry date to extract the benefits
- Losses in both cases are limited to the amount of premium paid which should also be factored in terms of the overall profitability.
- The underlying asset for the option contract is the same.
- The premium amount is to be borne by the buyer since it gives a benefit to the buyer for exercising the contract on or before the expiry date.
Also, check out Writing Put Options
Key Differences – Call Options vs Put Options
Despite the above, there are many differences which set apart Call Option vs Put Option:
- The buyer of a call option has the right but is not necessarily obligated to buy pre-decided quantity at a certain futuristic date (expiration date) for a certain strike price. Conversely, put options will empower the buyer with the right to sell the underlying security for the strike price at a futuristic date for a pre-determined quantity. However, they are not obligated for the same.
- A call option permits buying of an option whereas a put option will permit selling of an option.
- Call option generates money when value of the underlying asset is rising upwards whereas Put option will extract money when value of underlying is falling.
- As a continuation of the above, the potential gain in a call option is Unlimited due to no mathematical limitation in rising price of any underlying whereas the potential gain in a put option will mathematically restricted.
- Despite being bound by a single contract, the investor of a call option will look for a rise in the price of a security. Conversely, in the put option the investor expects the stock price to fall down.
- Both call and put options can be In the Money or Out of the Money. In case of call option the underlying asset price is above the strike price of the call. Out of the money indicates underlying asset price is below the call strike price. Another aspect is ‘At the Money’ meaning strike price and underlying asset price is the same. The premium amount will be higher for ‘In the Money option’ since it has an intrinsic value whilst premium is lower for Out of the Money call options.
With respect to put options, In the Money indicates underlying asset price below the strike price. Out of the Money is when the underlying asset price is above the put price. The premium amount for ‘In the Money’ option will be higher but the expectation of ‘in the money’ in this case is opposite to what it was in call option.
- Buying a call option requires the buyer to pay a premium to the seller of the call option. However, no margin has to be deposited with the stock exchange. However, selling a put requires the seller to deposit margin money with the stock exchange which offers the advantage to pocket the premium amount on the put option.
With respect to stock options, one call/put option represents 100 shares or a specific amount of the underlying asset and the price is quoted per share. Thus, to calculate how much buying the call/put option, price of the option has to be multiplied by 100.
The pricing of an option is a complex exercise as the premium is based on multiple factors such as:
- How far ‘in the money’ or ‘out of the money’ is the option contract
- Implied Volatility
- Time to expiry
- Option Greeks (Delta, Gamma, Vega, Theta, Rho)
The prices are largely based on the negotiations between the buyer and the seller. The premium will have 2 components i.e. Intrinsic Value and the Time Value (Extrinsic).
- Implied volatility refers to the estimated volatility in price of a security and is derived from the price of the option which is used as a gap to the pricing model for indicating the volatility of the stock at a later date. In case of long options, an increase in the volatility will add to the value and opposite if the implied volatility is decreasing. Thus, it is a way of estimating future fluctuations in the price of a security based on certain expected factors.
- The intrinsic value is a function of the Price and the strike price which equals the In-the-money amount of the option. The time value is the extension of the premium over the intrinsic value which cannot be capped. Hence, if the time to expiry is a while away, this time value can have a lot of influence on the pricing of the option since multiple factors can determine the movement of the underlying asset. Once the time to expiry nears, the impact of the extrinsic value will reduce. Thus,
- Time Value = Option Premium – Intrinsic Value
An option can be liquidated in the 3 ways:
- Closing buy or Sell
Call option owners can exercise their right to buy the underlying instrument whereas put option holders can exercise their right to sell such an underlying. Only option holders can exercise their option. This exercising is equivalent of buying or selling of the underlying for a consideration. In the money options are most certainly to be exercised at expiration since it puts the holder at an advantage than what currently existing in the market. Options which are out of the money than the transaction costs are exceptions to be exercised.
Most of the options exercise occurs with a few days to expiry remaining since the Time premium (time value of money) has dropped to a negligible level.
This is a renowned tool designed specifically for the investors to gauge the overall market sentiments. The ratio for the same is computed by dividing the number of put options traded by the number of call options traded. As this ratio increases, it can give an indication to the investors whether market is heavier on call or put. The ratio is primarily used by traders as an indicator when values reach an extreme level.
As the number of call options is found in the denominator, a fall in the number of call options will increase the value of the ratio. The significance is that market is dampening its bullish outlook. The users of this ratio will consider a large ratio as an opportunity to buy since the belief would be the market having a bearish prediction which will soon be adjusted when investors with short positions will look to cover the same.
Also, check out Put Call Parity
Call Options vs Put Options (Comparison Table)
|Basis for Comparison – Call Option vs Put Option||Call Option||Put Option|
|Meaning||It offers the right but not obligation to buy the underlying asset at a particular date for the pre-decided strike price||It offers the right but not the obligation for selling the underlying asset at a particular date for the pre-decided strike price.|
|Investor Expectations||Rise in the Prices||Fall in the prices|
|Profitability||The gains can be unlimited since price rise cannot be capped||Gains are limited since price can fall steadily but will stop at Zero.|
|Permits – Call Option vs Put Option||Buying the stock||Selling of Stock|
|Analogies – Call Option vs Put Option||Considered a security deposit allowing taking a product at a certain fixed price.||It is like an Insurance offering protection against a loss in value.|
Conclusion – Call Option vs Put Option
Entering into a call or put option is an entire game of speculation. If one has trust on the movement of the price of the underlying asset and is ready to invest some money with an appetite to bear the risk of premium amount, the gains can be substantially large. In terms of the Indian options market, a contract expires on the last Thursday of the month before which the contract should be executed else contract can be allowed to expire worthless with the premium amount foregone.
Thus, it completely depends on the risk appetite of the investor and the faith in the direction of the price movement of the underlying asset for which the option contract is undertaken. Call option and put options are two exactly opposite terms and a combination of speculation and financial ability will help in extracting maximum financial gains.