Options for Trading Investment Assets: Calls and Puts
8 of 10 in Series: The Essentials of Futures and Options Trading
Two types of options are traded. One kind, a call option, lets you speculate on prices of the underlying asset rising, and the other, a put option, lets you bet on their fall.
What's a call option all about?
A call option gives you the right to buy a defined amount of the underlying asset at a certain price before a certain amount of time expires. (Think of it as a bet that the underlying asset is going to rise in value.) If you don’t buy the asset by the time the option expires, you lose only the money that you spent on the call option.
You can always sell your option prior to expiration to avoid exercising it, to avoid further loss, or to profit if it has risen in value. Call options usually rise in price when the underlying asset rises in price.
When you buy a call option, you put up the option premium for the right to exercise an option to buy the underlying asset before the call option expires. When you exercise a call, you’re buying the underlying stock or asset at the strike price, the predetermined price at which an option will be delivered when it is exercised.
The attractiveness of buying call options is that the upside potential is huge, and the downside risk is limited to the original premium — the price you pay for the option.
What's a put option?
Put options are bets that the price of the underlying asset is going to fall. Puts are excellent trading instruments when you’re trying to guard against losses in stocks, futures contracts, or commodities that you already own. Buying a put option gives you the right to sell a specific quantity of the underlying asset at a predetermined price (the strike price) during a certain amount of time. Like calls, if you don’t exercise a put option, your risk is limited to the option premium, or the price you paid for it.
When you exercise a put option, you’re exercising your right to sell the underlying asset at the strike price. Puts are sometimes thought of as portfolio insurance, because they give you the option of selling a falling stock at a predetermined strike price. You can also sell puts.