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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.