Call and Put Options: A Beginner’s Guide to Trading Options

Call and Put Options: A Beginner’s Guide to Trading Options

Introduction 

When learning about options trading, there’s no better place to start than with call and put options. Understanding the basics of call and put options is an important foundation for any trader looking to enter the market. In this beginner’s guide to trading options, we will define call and put options, explain how they work, and compare their similarities and differences. 

We will also discuss the factors that determine option prices, the risks and rewards of options trading, and how to choose a reputable options broker. By the end of this post, you will have a solid understanding of the mechanics of calls and puts and be well on your way to making informed trades. 

Table of Contents 

• I. Introduction to options trading 
• II. Call options: definition and example 
• III. Put options: definition and example 
• IV. Comparing call and put options 
• V. Determining option prices 
• VI. Intrinsic and Extrinsic Value
• VII. Risks and rewards of options trading 
• VIII. Choosing an options broker 
• IX. Conclusion

The condensed version

Here are some bullet points summarizing the key points covered in the blog article:

• Options are financial contracts that grant the holder the right, but not the obligation, to buy or sell a specific asset at a predetermined price (strike price) on or before a specific date (expiration date).
• There are two main types of options: call options, which give the holder the right to buy an asset, and put options, which give the holder the right to sell an asset.
• Call options are considered bullish, as they profit from an increase in the underlying asset price. In contrast, put options are considered bearish, as they profit from a decrease in the underlying asset price.
• The price of an option is determined by the underlying asset, the strike price, the expiration date, and market conditions.
• Options trading carries the risk of losing the entire premium and significant losses if the underlying asset moves against the trader’s expectations but also offers the potential for unlimited profits.
• It is important to choose a reputable and reliable options broker, such as Tastytrade, Thinkorswim, or TradeStation.
• Before entering the options market, it is important to carefully research and understand the risks and rewards and consider your risk tolerance.

What is options trading?

Options trading involves the buying and selling contracts that grant the holder the right, but not the obligation, to buy or sell a specific asset at a predetermined price (called the strike price) on or before a specific date (called the expiration date). There are two main types of options: call options, which give the holder the right to buy an asset, and put options, which give the holder the right to sell an asset. Options can be used to speculate on the direction of market movements of stocks, indices, currencies, and commodities. They are also commonly used to hedge against potential losses in other investments. Options traders are those who aim to make profits, and in some cases a living, from trading options contracts.

Call options: definition and example 

A call option is a financial contract that gives the holder the right, but not the obligation, to buy a specific asset at a predetermined price (called the strike price) on or before a specific date (called the expiration date). The asset that the call option gives the holder the right to buy is called the underlying asset. Long Call options are considered bullish, as they give the holder the potential to profit from an increase in the underlying asset price.

For example, let’s say that Company X’s stock is currently trading at $50 per share, and you believe the price will rise in the next few months. You could purchase a call option with a strike price of $50 and an expiration date of three months from now. If the price of Company X’s stock rises to $60 before the option expires, the long call option contract now has $10 dollars of intrinsic value and can be sold, realizing a profit of $10 per share or $100 per contract. 

However, if the stock price does not rise above $50 per share, the option expires worthless, and you lose the premium you paid.

Put options: definition and example 

A put option is a financial contract that gives the holder the right, but not the obligation, to sell a specific asset at a predetermined price (called the strike price) on or before a certain date (called the expiration date). The asset the put option gives the holder the right to sell is called the underlying asset. Put options are considered bearish, as they give the holder the potential to profit from a decrease in the underlying asset price.

For example, let’s say that Company X’s stock is trading at $50 per share, and you believe the price will fall in the next few months. You could purchase a put option with a strike price of $50 and an expiration date of three months from now. If the price of Company X’s stock falls to $40 before the option expires, the long-put options contract would have $10 dollars of intrinsic value and can be sold, realizing a profit of $10 per share or $100 per contract. 

However, if the stock price does not fall below $50 per share, the option expires worthless, and you lose the premium you paid.

Comparing call and put options 

Call options to give the holder the right to buy the underlying asset at a predetermined price. In contrast, put options give the holder the right to sell the underlying asset at a predetermined price. Both types of options allow the holder to profit from movements in the price of the underlying asset, but in opposite directions: call options profit from an increase in the price of the underlying asset, while put options profit from a decrease in the price of the underlying asset.

Overall, call and put options are useful tools for speculating on or hedging against movements in the price of an underlying asset. The choice between a call option and a put option depends on your market outlook and risk tolerance.

Determining option prices 

There are several factors that determine the price of an option. The most important of these are:

• The underlying asset: the price of the option is partially determined by the current market price of the underlying asset. For example, a call option on a stock currently trading at $100 per share will generally be more expensive than a call option on a stock currently trading at $50 per share.
• The strike price: the strike price is the price at which the holder of the option can buy (in the case of a call option) or sell (in the case of a put option) the underlying asset. The intrinsic value is the difference between the strike price and the current market price of the underlying asset. Options with a higher intrinsic value will generally be more expensive than options with a lower intrinsic value.
• The expiration date: the closer the option is to expiration, the less time there is for the underlying asset to move in a favorable direction. As a result, options with longer expiration dates will generally be more expensive than options with shorter expiration dates.
• Market conditions: other factors that can affect the price of an option include the overall level of volatility in the market, the supply and demand for options on the underlying asset, or liquidity. 

In general, the price of an option is determined by the market and is based on the probability of the option being in the money at expiration. Options with a higher probability of being in the money will generally be more expensive, while options with a lower probability of being in the money will be less expensive.

Intrinsic and Extrinsic Value

In option contracts, intrinsic value refers to the amount by which the option is in the money, while extrinsic value refers to the amount of the option’s price that is not intrinsic value. For example, if a call option has a strike price of $50 and the underlying stock is currently trading at $60, the intrinsic value of the option would be $10, since the option holder can exercise the option to buy the stock at $50 and immediately sell it for $60. Any additional value beyond the $10 intrinsic value would be extrinsic value, also known as the option’s time value. This extrinsic value considers factors such as the remaining time until the option’s expiration date, and the volatility of the underlying stock.

Risks and rewards of options trading 

As every experienced options trader knows, options trading comes with risks, but those risks often come with the potential to earn a profit. A few of the risks and benefits are mentioned below:

• Risk of losing the entire premium: when you buy an option, you pay a premium to the seller. If the option expires worthless, you lose this premium. 
• Risk of significant losses: if you exercise an option and the underlying asset moves in the opposite direction to what you expected, you can incur significant losses. For example, if you exercise a call option and the underlying asset falls in price, or if you exercise a put option and the underlying asset rises in price, you will lose money. This is one of the many reasons that options traders do not exercise contracts when in the money. There is less risk when selling the option contract vs. exercising the contract. 
• Potential for significant profits: if the underlying asset moves in the direction you expected, you can realize significant profits by selling the contract. 
• Limited risk: when you buy an option, your potential loss is limited to the premium you paid. This is known as limited risk.
• Unlimited profit potential: long calls theoretically have an unlimited profit potential as they make money when the underlying asset increases in price. Although possible, we’ve never seen it happen. 

Overall, options trading can be risky but potentially lucrative to speculate on or hedge against market movements.

Choosing an options broker 

When choosing an options broker, it is important to consider several factors, including the broker’s fees, trading platform, and ease of use. Some of the best options brokers for options trading platforms include Tastytrade, Thinkorswim, and TradeStation.

Tastytrade is a popular choice for options traders due to its low fees and intuitive platform. The platform includes advanced charting and analysis tools, as well as a variety of educational resources to help traders hone their skills. Tom Sosnoff, the founder of Tastytrade is well-known in the options trading industry for the development of this platform, and Thinkorswim.

Thinkorswim is another popular options trading platform known for its advanced trading tools, extensive indicators, and educational resources. The platform is suitable for both beginner and advanced traders.

TradeStation is a professional-grade options trading platform that offers advanced charting and analysis tools and a variety of customizable options for traders. The platform is suitable for experienced traders who are looking for a high-performance trading experience.

When choosing an options broker, it is important to carefully consider your needs and preferences and do your research before committing to a particular platform.

Conclusion

In conclusion, call and put options are powerful financial instruments that can be used to speculate on or hedge against market movements. Understanding how they work is essential for any trader looking to enter the options market. In this beginner’s guide to trading options, we have defined call and put options, explained how they work, and compared their similarities and differences. We have also discussed the factors that determine option prices, the risks and rewards of options trading, and how to choose a reputable options broker. 

By following the guidelines outlined in this post, you can gain a solid foundation for successful options trading. However, it is always important to research and carefully consider your risk tolerance before entering the market.

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