What is the Difference Between Call and Put Option?
Call and put options are two sides of the options market. Here we look at the difference between the call option and the put option. The essential difference between call option and put option arises from the fact that one is an option to buy an underlying asset and the other an option to sell the asset. Having understood the difference between call and put options, we will then move to the nuances of calls and puts. Let us look at the call vs put option in detail.
Difference Between Call and Put Option
Here we look at some interesting points of comparison incall vs put options about the F&O market.
- A call option is a right to buy an underlying asset or contract at a fixed price at a future date but at a price that is decided today. On the other hand, the put option is the right to sell an underlying asset or contract at a fixed price at a future date but at a price that is decided today.
- Both the call option and the put options are rights without the obligation which is what makes them an asymmetrical option. The call option has a buyer and a seller just as a put option also has a buyer and a seller.
- The buyer of a call option has the right although the buyer is not necessarily obligated to buy a pre-decided quantity at a certain futuristic expiration date for a certain strike price. On the other hand, put options empower the buyer with the right to sell the underlying security for a futuristic date for a pre-determined quantity. However, they are not obligated for the same.
- A call option is a right to buy whereas the put option is a right to sell. Therefore, the call operation generates profits only when the value of the underlying asset is rising upwards. On the other hand, the put option will generate profits to the buyer of the put option only when the value of the underlying is falling.
- In a call option, the potential gain is unlimited due to no mathematical limitation in the rising price of any underlying. Technically, the price can go all the way to infinity. On the other hand, in the case of put options, the potential gain in a put option will mathematically be restricted, because technically, the price of a stock cannot be zero.
- Let us turn to expectations now. While being bound by a single contract, the buyer of a call option will look for a rise in the price of a security. The greater the rise the better because the cost of the call option also has to be covered. Conversely, in the put option, the investor expects the stock price to fall.
- Call options can be in the money or out of the money. For example, if the call option spot price is greater than the strike price then it is called the in-the-money or ITM option. However, if the spot price is less than the strike price then it is called out of the money or OTM option. In the case of put options, it will be in the money or out of the money. For example, if the put option spot price is less than the strike price then it is called the in-the-money or ITM put option. However, if the spot price is greater than the strike price then it is called out of the money or OTM put option.
- The trader who writes a call option at a strike price has a non-affirmative view that the stock price will not go above the strike price. For the seller of the call option, the break-even will be the strike price of sale plus the premium received. The losses for the seller will start after that point and below the strike price, the entire premium can be pocketed. The trader who writes a put option at a strike price has a non-affirmative view that the stock price will not go below the strike price. For the seller of the put option, the break-even will be the strike price of the put sale minus the premium received. The losses for the seller will start after that point and above the strike price the entire premium can be pocketed by the seller of the put option.
What are option premiums?
Options premium is the price traders pay for a call option or put option. When you buy an option, you get the right to trade its underlying market at a specified price for a set period. The price you pay for this right is called the option premium. Remember, the option premium or the option price is the price paid for this right without the obligation.
The option premium is influenced by 3 factors viz price of the underlying contract, level of volatility, and time to expiry. Option premium or option price means the same thing and it is compensation for this right without the obligation.
In mathematical terms, the option premiums can be shown as the sum of the time value of the option and the intrinsic value of the option.
Calculating the option premium and interpreting it
Let us look at it this way. For example, if a call option has an intrinsic value of Rs.15 and a time value of Rs.10, then you will have to pay Rs.25 to purchase the call option as that would be the price of the call option in the market. To make a profit from the option, you’ll need to sell the call option in the market when it is more than Rs.25. Alternatively, if you are going to exercise the option, then your stock price should be able to cover the cost of the strike plus the option cost and leave you with a small profit margin.
The option premium, logically, has two components viz. the intrinsic value and the time value. Now the intrinsic value is more straightforward as it is the difference between the option’s strike price and the current price of the underlying market. For call options, intrinsic value is calculated by deducting the strike price from the underlying spot price. For put options, intrinsic value is calculated by subtracting the underlying price from the strike price. So, that is how the logic of ITM and OTM for call and put options change accordingly.
Time value and time decay in option premiums.
Time to expiry is an important parameter impacting the option premium time value. Time to expiry does not have an impact on the intrinsic value but it has a strong impact on the time value of the option and thus impacts the option premium in a significant way. The longer an option has before it expires, the more time the underlying market has to pass the strike price and vice versa. For a call option and a put option, the longer the time to expiry, the greater is the time value of the option and hence the higher the option premium. You might consider paying more for the option with the longer expiry, as it gives more time for you to make a profit on the deal.
An important aspect of option premium, especially for option sellers is time decay. Falling time value is known as time decay, a risk that options buyers dread and option sellers enjoy. As an option nears expiry, time decay means that its value will drop at an increasingly sharp rate of fall.
Frequently Asked Questions Expand All
That would depend on the stock price movement this decision would depend on which of the options is intrinsically under-priced using the Black & Scholes model.
A call option example is a right to buy RIL at Rs.2250 for a premium of Rs.25.
A put option example is a right to sell RIL at Rs.2250 for a premium of Rs.20.
The call option is valuable when the price goes above Rs.275 and the put option is valuable if the price goes below Rs.2230.