If you're interested in options trading, one of the first things to learn is the difference between call and put options. You'll see these terms used all the time, so understanding them is a must.
A call option is the right to buy a stock at a specific price by an expiration date, and a put option is the right to sell a stock at a specific price by an expiration date.
That's the short summary of these options contracts. Now, let's take a closer look at how call and put options work, as well as the risks involved with options trading.
How does a call option work?
A call option is a contract tied to a stock. You pay a fee, called a premium, for the contract. That gives you the right to buy the stock at a set price, known as the strike price, at any point until the contract's expiration date.
Strike Price
Risks of call vs. put options
The risk of buying both call and put options is that they expire worthless because the stock doesn't reach the breakeven point. In that case, you lose the amount you paid for the premium.
It's also possible to sell call and put options, which means another party would pay you a premium for an options contract. Selling calls and puts is much riskier than buying them because it carries greater potential losses. If the stock price passes the breakeven point and the buyer executes the option, then you're responsible for fulfilling the contract.
The benefit of buying options is that you know from the beginning the maximum amount you can lose. This makes options safer than other types of leveraged instruments such as futures contracts.
Related investing topics
However, options can be riskier than simply buying and selling stocks because there's a greater possibility of coming away with nothing. When investing in stocks, you only need to predict whether the stock goes up or down. For options trading, you need to predict three things correctly:
- The direction the stock will move.
- The amount the stock will move.
- The time period of the stock movement.
If you're wrong about any of those, then the options contract will be worthless. While there's the potential for greater returns with options, they're also harder to trade successfully.
Despite the challenge of successfully trading call and put options, they provide an opportunity to amplify your returns. That can make them a valuable addition to a balanced portfolio. For investors interested in options, there are also more advanced strategies that go beyond buying calls and puts.
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About the Author
Lyle Daly has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Apple and Netflix. The Motley Fool has a disclosure policy.
