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How Do Calls and Puts Work

There are two types of stock options: calls and puts. A call option gives the holder the right to purchase the stock, puts allows the holder to sell.

A.J. Arango

26 May 2024 • 9 min read

Puts and Calls Explained

What are Stock Options?

A stock option is a financial derivative that grants the holder the right, but not the obligation, to buy or sell a specified amount (usually 100 shares) of an underlying stock (or Fund) at a predetermined price (the strike price) within a set period. There are two types of stock options: calls and puts. A call option gives the holder the right to purchase the stock, while a put option allows the holder to sell it.

This sounds very complicated, and there is much to unpack, but we will cover the basics. By the end, you will better understand how calls and puts work and the differences between them.

As a shortcut, traders say "stock option" or "option." More precisely, "options contracts" exist for stocks, ETFs (exchange-traded funds), and futures. We will say "stock options" or "options" for simplicity.

Think of options as a contract between a buyer and a seller. In options transactions, the buyer holds the 'option' to force the seller to buy or sell 100 shares of a stock or EFT by a specific date.

Understanding that almost all stock options are traded in 100 shares per contract lots is critical to grasping their pricing and value. This knowledge will empower you in your investment decisions. The following sections will delve deeper into the differences between calls and puts.

Difference Between Call and Put Options

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Calls and puts are the only two types of stock options.

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Options have four characteristics that distinguish one from another: Type, Strike, Expiration, and Underlying.

All options are distinguished from each other by four factors — Put vs Call: Which, When, and Where

Type - Options will be Calls or Puts (Calls vs. Puts).

Calls give the owner the right (but not the obligation, aka "the option") to BUY an underlying security at a specific price, on or before a particular time. There are two ways to transact in call options:
- "Buy a Call" is known as going "long" a call. Generally, going long a call is profitable when the price of the underlying INCREASES in value (goes up in price, bullish strategy).
- "Sell a Call" is also known as going "short" or "shorting" a call. Selling a call is usually profitable when the price of the underlying decreases (bearish strategy).
Puts give the owner the right to SELL an underlying security at a specified price on or before a specified date. There are also two ways to trade input options:
- "Buy a Put," also known as going "long" a put, is typically done to hedge risk or speculate on the decrease in an underlying price. The value of a put INCREASES when a stock or ETF loses value (bearish strategy).
- "Sell a Put," commonly referred to as "shorting" or "going short." Selling a put is profitable when the price of a stock/EFT stays above the strike price.

Buying calls and selling puts are both bullish — Four ways to trade options

Underlying - This is the asset that the option is based on (which). This asset can be a stock, ETF, or Future.

A stock option is a financial derivative. That means that the option's price is "derived" from (or is based on) the price of an underlying stock or ETF. If a share of XYZ Corp. increases or decreases, the option's value will correspondingly change. In this case, the option is the "derivative," and the stock is the "underlying."
There is an option market for most large publicly traded stocks and EFTs. This makes it possible to trade almost any well-known stock with less capital but a different risk profile.

Sell a put option basics — Option contract example

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The liquidity of an option will have a significant impact on the profitability of trading that asset.

Expiration Date—The last day the option contract will be valid. After the expiration date, the contract will either be worthless or assigned (when).

Assignment is the act of exercising an option contract. For a call option holder (buyer), assignment involves purchasing 100 shares of the underlying stock at a predetermined price. For a put contract holder, the assignment consists of selling 100 shares of the underlying stock at a predetermined price.
The seller of the options will be on the other side of those assignments. Put sellers will buy 100 shares of the underlying, and call sellers will sell 100 shares at the predetermined price.

Strike Price—This price will determine the option's value relative to the underlying. Ultimately, the price of the underlying relative to the strike price at expiration will decide the option's market value. (where).

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Options have two types of value: Extrinsic and Intrinsic.

Call options are more valuable above the strike price.
Put options are more valuable below the strike price.
Stock options are often referred to as "in the money/ITM," "out of the money/OTM," and "at the money/ATM."
- An in-the-money / ITM call will have an underlying price above the strike price.
- An in-the-money / ITM put will have an underlying price below the strike price.
- An out-of-the-money / OTM call will have an underlying price below the strike price.
- An out-of-the-money / OTM put will have an underlying price above the strike price.
- All at-the-money / ATM options will have an underlying right at the contract's strike price.

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Note that ATM options usually have the highest premium-to-value ratio (most extrinsic value, all other factors being equal)

Intrinsic vs. Extrinsic Value

Option value is made up of two parts: intrinsic and extrinsic value.

The Intrinsic value is the amount of money the option would be worth if it expired immediately. For example, an option with a strike price of ten for a stock with a current price of eleven has one dollar of intrinsic value.

The extrinsic value of an option is related to many factors beyond the scope of this discussion but is often referred to as "time value." Extrinsic value is the value of the option beyond the intrinsic value. All other factors being equal, the option's value will decrease as time passes. That decrease in value is entirely due to a reduction in extrinsic value.

Option Trading Basics

One factor that must also be included is the "premium" or cost of the option. The premium is the price the buyer pays the seller to execute the contract. Option premiums are calculated based on market demand and are equal to the intrinsic plus the extrinsic value.

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Remember, options are just contracts to buy or sell a security before a specified date at a specified price. The premium compensates the option seller for the risk or opportunity cost of joining the contract.

Both the buyer and seller of the option need to agree that the premium is worth the risk and opportunity cost of the transaction.

Using the information above and plenty of time, anyone can extrapolate how to trade options for income, capital appreciation, or risk hedging. Nevertheless, we will use examples to explain option trading basics and frame the examples to quickly develop an accurate understanding of how to trade profitably.

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Understanding each of the four components of a stock option is relatively straightforward. However, when combined, it becomes significantly more complex.

Call Options Explained

As we said above, you can either buy or sell a call. Below, we will use a simple example. A call provides a chance to buy a security at a predetermined price by a predetermined date for a specified premium.

For example, assume you own a baseball card worth $100.00. You have a friend who would like to buy your card, but either doesn't have the money today or doesn't want to commit the entire $100.00 to buy it now.

Instead, you, being an industrious person, make a deal. You tell your friend that if they give you $10.00 today (premium), you will hold the card until Jan 1st next year (expiration date), and they can buy (making this a call) from you for $110.00 (strike price). If they buy or don't buy the card, you, as the seller , will keep the premium (the seller keeps the premium, no matter the outcome).

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Option Sellers are known as "writers" of the option

Your friend agrees and pays you the premium. After a few months, the price of the card in the market has surged to 115.00, and with only a few days left in the contract, your friend decides to execute the option. This decision, known as 'assignment,' could potentially lead to a significant profit for your friend, highlighting the lucrative nature of options trading.

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Options Buyers are known as "holders" of the option

Your friend will give you $110.00 (the agreed strike price), and you hand over the baseball card. Your friend receives a baseball card worth $115.00 at the agreed time and a specified price. You received $10.00 of the premium and $110.00 for the card. Both parties are satisfied with the transaction (though satisfaction is not required).

Both the option buyer and seller agree to the terms of the contract — The option seller gets a premium, and the option buyer gets a choice.

Why Use an Option to Do This Transaction?

Using options, the seller of the asset was able to make some near-term income in the present while participating in the limited upside of price appreciation. The upside is limited to the price of the asset at the strike price plus the premium. Also, a call seller reduces the downside risk of owning the asset by selling the call.

The option buyer, on the other hand, was able to lock in the price of an asset for a future date without committing to the entire expense in the present. Options make it possible to speculate on the price of an asset with limited downside risk (buying an option means the downside risk is up to and including the entire premium spent) while reducing the current expense. This characteristic of options is referred to as leverage. Leverage can amplify returns but can also amplify risk.

Click the link for more details on how calls work.

Put Options Explained

Put options are a little harder to grasp, but they make sense once you have a basic understanding.

A put option contract provides a chance to SELL a security at a predetermined price by a specified date for a predetermined premium. People buy put options for various reasons, but generally, they are done to force a counterparty to BUY a security that is owned at a predetermined price. Buying a put can provide downside risk by allowing the buyer to unload an asset if the price falls.

Let's use a tangible asset like a rare coin as an example. Collectibles, like all assets, can be subject to dramatic price reductions, and buying a put option could be just the insurance a coin collector wants to protect themselves.

Buying a Put on a rare coin could protect your investment.

As a rare coin collector, assume you own a Morgan Silver Dollar from 1846. It is worth $250.00 in the collectibles market. You believe the coin will appreciate in value, but you also have a lot of your money tied up in this coin. You understand that the market can be volatile, so to protect yourself, you make a deal with a local dealer.

You tell them that you would like to sell the coin to them for 200.00 by Jan 1st next year if the price goes down. You and the dealer agree that the current price is 250.00, and the dealer says they will keep the contract open for the specified time if you pay them 25.00 today.

Transaction explained:

Underlying: Morgan Silver Dollar
Strike Price: $200.00
Expiration: Jan 1st next year
Option Type: Put (the option contract holder can "put" the asset to the option writer)

As time goes by, the coin actually appreciates in value up to $315.00. By the time the expiration date arrives, you would not be willing to part with your prize coin for 200.00, so the "put contract" expires worthless. The local dealer keeps the 25.00, and you are happy your asset increased in value.

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Hopefully, these simple examples helped provide option trading basics and demystify how traders use options to hedge risk, speculate price, and generate income. This was just an abbreviated options 101 crash course, but if you found value or want to learn more, please subscribe to receive more advanced insight and future valuable digital products to help you navigate your options vending journey.