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Options Trading: Calls and Puts Explained ∙ Difference ∙ Examples

Learn the difference between buying and selling calls and puts in the stock market. Understand how the direction of price movements affects profit and loss. Discover what to do during both bullish and bearish movements. Examples and explanations provided.


Difference of Calls and Puts in Options Trading

UNDERSTANDING THE DIFFERENCE BETWEEN BUYING AND SELLING CALLS AND PUTS


The difference between buying and selling calls and buying and selling puts lies in the direction of the expected price movement of the underlying asset and the corresponding profit and loss outcomes.

  • Buying a call or a put is a bet on the direction of the price movement of the underlying asset.

  • Selling a call or a put, on the other hand, is a bet on the opposite direction.


Buying Calls

Buying a call option gives you the right, but not the obligation, to buy an underlying asset at a specified price (strike price) before a certain date. If the market price of the underlying asset rises above the strike price, the buyer of the call option can purchase the asset at the lower strike price, resulting in a profit. Therefore, when buying a call, the investor expects the price of the underlying asset to rise and profits when the price rises above the strike price.


Selling Calls

On the other hand, selling (or "writing") a call option obligates the seller to sell the underlying asset at the strike price if the buyer of the option decides to exercise it. This can result in a loss for the seller if the market price of the underlying asset rises above the strike price. Therefore, when selling a call, the investor expects the price of the underlying asset to stay the same or decline and may have to sell the underlying asset at the lower strike price if the buyer of the option decides to exercise it.


Buying Puts

Buying a put option gives you the right, but not the obligation, to sell an underlying asset at a specified price (strike price) before a certain date. If the market price of the underlying asset falls below the strike price, the buyer of the put option can sell the asset at the higher strike price, resulting in a profit. Therefore, when buying a put, the investor expects the price of the underlying asset to fall and profits when the price falls below the strike price.


Selling Puts

On the other hand, selling (or "writing") a put option obligates the seller to buy the underlying asset at the strike price if the buyer of the option decides to exercise it. This can result in a loss for the seller if the market price of the underlying asset falls below the strike price. Therefore, when selling a put, the investor expects the price of the underlying asset to stay the same or rise and may have to buy the underlying asset at the higher strike price if the buyer of the option decides to exercise it.

 

Buying a call option is considered a bullish bet because the investor is betting that the price of the underlying asset will rise.


Buying a put option is considered a bearish bet because the investor is betting that the price of the underlying asset will fall.


Selling a call option is considered a bearish bet because the seller is betting that the price of the underlying asset will not rise above the strike price.


Selling a put option is considered a bullish bet because the seller is betting that the price of the underlying asset will not fall below the strike price.


Options Trading Chart Simple

EXAMPLES OF BUYING AND SELLING CALLS AND PUTS


CALLS

Suppose you believe that the stock price of ABC Inc. will rise in the near future, and you want to profit from this expected price increase. So, you decide to BUY a call option with a strike price of $70 and expiration in 3 months. The cost of this option is $2 per share.

After 3 months, the stock price of ABC Inc. has indeed risen to $75 per share. Since the stock price is now above the strike price of $70, you decide to exercise your call option. This means you buy the stock at the lower strike price of $70, even though the market price is $75. By doing so, you make a profit of $3 per share ($75 market price - $70 strike price - $2 cost of the option).

On the other hand, if you had SOLD (written) a call option with the same strike price and expiration, you would be obligated to sell the stock at $70 if the buyer of the option decided to exercise it. If the market price of ABC Inc. rises to $75, the buyer of the option would make a profit of $5 per share by exercising it ($75 market price - $70 strike price). In this case, you as the seller of the option would incur a loss of $3 per share ($75 market price - $70 strike price).


PUTS

Suppose you believe that the stock price of XYZ Inc. will fall in the near future, and you want to profit from this expected price decline. So, you decide to BUY a put option with a strike price of $50 and expiration in 3 months. The cost of this option is $2 per share.

After 3 months, the stock price of XYZ Inc. has indeed fallen to $45 per share. Since the stock price is now below the strike price of $50, you decide to exercise your put option. This means you sell the stock at the higher strike price of $50, even though the market price is only $45. By doing so, you make a profit of $3 per share ($50 strike price - $45 market price - $2 cost of the option).

On the other hand, if you had SOLD (written) a put option with the same strike price and expiration, you would be obligated to buy the stock at $50 if the buyer of the option decided to exercise it. If the market price of XYZ Inc. falls to $45, the buyer of the option would make a profit of $5 per share by exercising it ($50 strike price - $45 market price). In this case, you as the seller of the option would incur a loss of $3 per share ($50 strike price - $45 market price).

PUT-CALL RATIO

The put-call ratio, which is the ratio of trading volume of put options to call options, is often used as an indicator of market sentiment.

  • A higher put-call ratio indicates that more put options are being bought relative to call options, which suggests a bearish market sentiment.

  • On the other hand, a lower put-call ratio indicates that more call options are being bought relative to put options, which suggests a bullish market sentiment.


However, it's important to note that the put-call ratio is not a perfect indicator of market sentiment and should be used in conjunction with other indicators and analysis. Market sentiment can also be influenced by various other factors, such as economic data releases, company news, and overall market conditions.


If the put-call ratio is 0.5:1, it suggests a bullish market sentiment as more call options are being bought relative to put options. But, as mentioned, this should not be the only consideration when analyzing market sentiment.

Options Trading

FACTORS THAT INFLUENCE THE PRICE OF OPTIONS


Greeks Definition

In options trading, Greeks are a set of mathematical measures that are used to help traders understand how an option's price is affected by changes in different factors, such as the underlying stock price, time to expiration, volatility, and interest rates.

  1. Implied Volatility (IV) - A measure of the expected volatility of the underlying asset's price, which is derived from the price of options. Higher IV implies greater uncertainty about the future price of the underlying asset and is often used as a gauge of market risk.

  2. Delta - A measure of the rate of change of an option's price with respect to the price of the underlying asset. It indicates how much the option price is expected to change for every dollar change in the price of the underlying asset.

  3. Theta - A measure of the rate of decay of an option's price over time, reflecting the effect of the passage of time on the option's value. It represents the option's time decay and is often used to evaluate options strategies that rely on time decay.

  4. Gamma - A measure of the rate of change of an option's delta with respect to the price of the underlying asset. It represents how much the delta is expected to change for every dollar change in the price of the underlying asset.

  5. Open Interest - The number of outstanding option contracts that have not yet been exercised or expired. Higher open interest indicates greater market interest in the option and can be used to gauge market sentiment.

Greeks Example

Suppose you are considering buying a call option on XYZ stock, which is currently trading at $100. The option has a strike price of $105, expires in three months, and has the following characteristics:

  1. Implied Volatility (IV) - The current IV is 20%. This indicates that the market expects the price of XYZ stock to be highly volatile in the next three months.

  2. Delta - The delta of the option is 0.75. This means that if the price of XYZ stock rises by $1, the option price is expected to increase by $0.75.

  3. Theta - The theta of the option is -0.05. This means that for every day that passes, the option price is expected to decrease by $0.05. This can be useful in evaluating options strategies that rely on time decay.

  4. Gamma - The gamma of the option is 0.05. This means that for every $1 increase in the price of XYZ stock, the delta is expected to increase by 0.05.

  5. Open Interest - The open interest for the option is 500 contracts. This indicates that 500 option contracts are outstanding and have not yet been exercised or expired. A higher open interest can suggest greater market interest in the option and can be used to gauge market sentiment.

By considering these indicators, an investor can get a better understanding of the risk and reward potential of the option, as well as the market's expectation of the underlying stock's future price movement. It's important to use these indicators in conjunction with other forms of analysis, such as technical and fundamental analysis, to make informed investment decisions.

Greek Terms

  1. Gamma Neutral: Gamma is a measure of the rate of change of an option's delta with respect to the price of the underlying asset. A gamma neutral position is a position where the overall gamma value is zero, meaning that the overall delta of the position is not expected to change significantly with small changes in the price of the underlying asset. This can be achieved by combining long and short options positions in such a way that the overall gamma value is zero.

  2. Delta Neutral: Delta is a measure of the rate of change of an option's price with respect to the price of the underlying asset. A delta neutral position is a position where the overall delta value is zero, meaning that the overall position is not expected to benefit or lose from small price changes in the underlying asset. This can be achieved by combining options and the underlying asset in such a way that the overall delta value is zero.

  3. Gamma Max: The term "gamma max" is not a commonly used term in the financial industry. However, it may refer to a situation where the gamma value of an option is at its maximum, meaning that it has the highest rate of change with respect to the price of the underlying asset. This can be used as a measure of the risk of the option.

  4. Theta Neutral: Theta is a measure of the rate of decay of an option's price over time. A theta neutral position is a position where the overall theta value is zero, meaning that the overall position is not expected to lose value due to the passage of time. This can be achieved by combining options positions in such a way that the overall theta value is zero.

  5. Gamma Ramp: is a term used to describe the rate at which the gamma value of an options position changes with respect to changes in the price of the underlying asset. The gamma ramp can be visualized as the slope of the gamma curve, which shows how the gamma value changes as the price of the underlying asset changes. In options trading, the gamma ramp can be used to understand the risk associated with an options position, as the gamma value indicates the rate of change of an option's delta with respect to changes in the price of the underlying asset. A higher gamma ramp suggests that the option's delta is expected to change more rapidly with changes in the price of the underlying asset, which can lead to increased risk.

These are just a few of the many terms used in options trading and analysis, and they can be used to help manage risk and optimize returns in options trading. However, it's important to use these concepts in conjunction with other forms of analysis and to understand the underlying mechanics and limitations of each concept.


 

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