There are two types of option contracts: Call Options and Put Options.
Call Options give the option buyer the right to buy the underlying asset.
Put Options give the option buyer the right the sell the underlying asset.
The simple examples so far have only been call options i.e. giving you the right to buy the underlying asset. You're probably already thinking "what about if I want to sell the shares instead of buy them at $25?". That is why these two types of option contracts (Calls and Puts) exist.
In our previous example, Peter bought a call option from Sarah. Peter also could have bought a put option from Sarah. Buying a put option means that Peter buys the right to sell Microsoft shares at $25 on the 5th of May. Therefore Peter will make a profit if the market is below $25 on the day of expiration.
Buying put options enables investors to profit when the markets fall without having to sell short stock.
Buyers of put options have unlimited profit potential if markets begin to sell off. Put option holders also have limited risk if the market goes against them i.e. up.
To get a better understanding of the payoff of a put option, take a look at the following option strategy graphs:
Long Put Option (Buying a Put Option)
Short Put Option (Sell a Put Option)
And then compare put option graphs to the following call option graphs:
Long Call Option (Buying a Call Option)
Short Call Option (Selling a Call Option)
Comments (39)
Peter
December 20th, 2011 at 4:58pm
Hi Daniel,
It depends where you are trading and what broker you use. I use Interactive Brokers and they don't charge any exercise/assignment fees/commissions anywhere except in Australia.
Daniel
December 20th, 2011 at 4:19am
Mr Peter,
when do the exercise, who among call writer, put holder, put writer and call holder will pay for the exercise?
Peter
December 12th, 2011 at 11:25pm
Hi Ravi,
A long position is where you have paid money and own "rights" to the asset - in the case of options, you have the right to exercise the option.
A short position is where you have sold something that you don't actually own. When you short options you receive money upfront as a result of the transaction but the right to exercise sits with the buyer (holder) of the option.
Ravi
December 12th, 2011 at 3:00am
Dear Sir,
1. what is the difference between short and long position?
I wonder whether what situation short sale is allowed?
Peter
December 8th, 2011 at 3:24am
Hi Daniel,
Option buyers (holders) pay the premium to the option sellers (writers). So, sellers receive the money up front when the trade takes place.
Daniel
December 8th, 2011 at 3:14am
Hi Peter, could you please help me?
I want to know who are can make payment and receive payment among of call option writer, put option writer, call option holder and put option holder.
Peter
November 21st, 2011 at 7:43pm
The strike price is the price that you will have to buy or sell the underlying at if the option is exercised.
ciyera
November 21st, 2011 at 12:24pm
what is strike price? and how its related to both calll and buy options?
Peter
November 19th, 2011 at 5:28am
Please see the page Why Trade Options.
Sarah
November 18th, 2011 at 4:35pm
When do we use options? And why do we use it?
Peter
November 17th, 2011 at 4:09pm
If the call option is out of the money at the expiration date then the strike price will be higher than the current market price - so you would be better buying the stock directly via the exchange.
Rajesh
November 17th, 2011 at 8:33am
Hi Peter,
I have a question here. If we buy a call option and upon expiry the option is out of money, can we buy the underlying stock at the strike price(IN INDIA)? If yes, how much quantity we need to buy (Is it the lot size or for the money which we invested for the option)? Please help me.
Eli
October 7th, 2011 at 5:28am
It was an assignment question and my answer was the value of options are same when the underlying price is equal to the strike price I hope my answer is correct.
Again thank you so much for your quick reply.
Peter
October 6th, 2011 at 5:20pm
Hi Eli,
The options will be approximately equal when the strike price is the same as the stock price (ATM).
Well, it's really when the "forward price" of the stock is the same as the strike price where the forward price takes into consideration the interest rates and dividends of the stock.
Eli
October 6th, 2011 at 3:56pm
Hi Peter,
Many thanks for your kind response. I learned many terms via your answers :)
My question is that in what condition the value of a call option and a put option of a stock with the same maturity date can be equal?
Peter
August 13th, 2011 at 11:27pm
No, there is no obligation as the trader no longer has a short position.
kanchan
August 13th, 2011 at 4:42am
if the seller sold a call option of X at a premium of $10 .. and before the expiry date the premium reduces to $4 .. he buys back the option and makes a profit of $6 ... is he still obliged to buy the shares if the buyer of the option exercises the option ?
kanchan
August 13th, 2011 at 4:31am
@ rachel
so the seller will take the delivery of the shares ? wat if he does not have enough cash in his account to buy the shares ?
Peter
August 7th, 2011 at 7:45am
Well put Rachel!
Rachel
August 6th, 2011 at 7:36pm
Kris
April 6th, 2010 at 11:00pm
Hi,
Quick question. What i don't understand about put options is using your example above, though you have the right to sell the put option for $25, and say at expiration the maket value for the shares is $20?. Who would want to buy the shares at $25 when it's already at $20?
---------------------------------------------------
You may like to understand what the two parties of the options contract are. There are two parties: the writer and the holder. The person who bought the put option is also called the holder. He has the right but not the obligation to sell the underling stock. However, the writer also known as the seller has the obligation to buy back the underlying stock if the holder choose to exercise the put option.
So the seller of the put option will buy back the stock if the buyer of the put option choose to exercise their right, even when the market price if much lower than the exercise price.
Peter
May 18th, 2011 at 5:44pm
Yep, you can have bonds and bills as underlying assets - you can also trade options on an index, forex, commodity futures, agricultural futures and even weather futures. Check out the CME for more.
toyin
May 18th, 2011 at 3:10am
to my understaning option to be exercised base on underlying asset.fine and the underlying asset mentioned is shares,can we used Treasury bills and bonds as underlying asset
Peter
February 23rd, 2011 at 3:52pm
If the options are ITM then you won't have any trouble selling them back - there will always be a buyer. The buyers will almost always be market makers who are obligated by the exchange to provide a two way market in option contracts. Market makers will place bids on these ITM options based on the fair value of the option in an attempt to hedge it back with the underlying stock.
Paul
February 23rd, 2011 at 9:40am
Thanks Peter. One last question.
If options depreciate as they near their expiry date are they difficult to sell even if they are well in-the-money? Why would the option value matter when the broker will pay the profit even after the option expires?
Peter
February 22nd, 2011 at 7:55pm
Hi Paul,
All options can be traded out (i.e. sold back) prior to expiration - regardless of the settlement type.
And yes to your second question - as settlement type is irrelevent you can sell the option back in market to realize a profit.
Physical delivery just means that if you do hold the option until the expiration date and decide to "exercise" the option, you will need to deliver (or be delivered) the underlying asset that the option is based on - as apposed to simply receiving a cash settlement.
Paul
February 22nd, 2011 at 3:57pm
Hi Peter,
Me again. I`ve pasted one of your earlier examples below. My question is: If the option in the example below were a physical settled option, could you still sell the option for $2? If so, why is it called a physical settled option? Thanks.
Say you bought a $25 call option for $1 while the underlying shares were trading at $26. If the market rallies to $27 the option must at least be worth $2 because you can exercise your right at $25. So, even though the shares only went up 3.8% you DOUBLED your money because you can now sell back the option for $2.
Paul
February 22nd, 2011 at 3:43pm
Hi Peter.
Thanks.
Another question: Would it be correct to say that a physical delivery option is an option which must be exercised and cannot be sold?
Peter
February 22nd, 2011 at 5:16am
Hi Paul, there isn't anything about the option that tells you the settlement type - you just have to check out the specifications with the exchange. If you search the exchange website for "contract specifications" you'll usually find it ok.
Generally speaking I would say that equity options (options based on a stock) are physically settled and index options are cash settled.
Paul
February 22nd, 2011 at 4:57am
Hi. Can you tell me how to distinguish between physical delivery options and cash settled options. In other words, if I only want to buy options which can be sold for cash - how can I distinguish these from physical delivery options. Thanks.
Peter
January 19th, 2011 at 9:46pm
Hi Sash,
Thanks for the positive feedback!
Now, about the option - it depends on how bullish you are on the stock. That is ti say how far you think the stock will move after the open. At-the-money options are most sensitive to stock price changes and hence will have large gains initially, however, the further the stock moves away from the strike price the less sensitive the changes become.
For this reason you may want to look at options that are slightly out-of-the-money. This way as the stock approaches the strike price it becomes more sensitive to the stock price movements and the option's percentage return will be far greater.
This concept of sensitivity has to do with the option's Delta (sensitivity to stock price movements) and Gamma (the option's delta sensitivity).
If you expect a very large move, then you would choose an option that is very far out-of-the-money, which would likey have a very low purchase price. And as the stock rallies hard towards the strike price the more value it gains - but more importantly the more percentage gain on the initial purchase price of the option.
Sash
January 19th, 2011 at 8:31pm
Hello Mr.Peter,
First of let me THANK YOU for putting together this site. I am lucky to stumble across this site. You did a great job explaining a concept that is so difficult to understand (atleast for me).
My Question is: Lets say I determine (based on research) that a particular stock (eg:X) is going to go up today before the stock exchange open. Instead of buying X at $55, can I buy the corresponding call option for X? If so, how do I determine which call option to pick? Should I select a call option that has high open interest or should I go with an option that has high volume? Or neither?
Thank you so much again! Good bless your heart!
Peter
September 23rd, 2010 at 6:02am
Yes, the stock price can only go to zero, but the terminology for the profit on the option is still most commonly known as being "unlimited".
Dave
September 21st, 2010 at 6:55pm
There is an error in your text in paragraph 8. It says "buyer's of put options have unlimited profit potential" when in fact profit is limited at 0.
Peter
April 8th, 2010 at 10:51am
Hi Kris, nobody would but that is the risk you take when you "sell" an option as apposed to "buy" an option. The buyer has the "right" to exercise and the seller has the "obligation" to deliver if the buyer decides to exercise.
Kris
April 6th, 2010 at 11:00pm
Hi,
Quick question. What i don't understand about put options is using your example above, though you have the right to sell the put option for $25, and say at expiration the maket value for the shares is $20?. Who would want to buy the shares at $25 when it's already at $20?
Peter
May 12th, 2009 at 6:32am
Hi Glen,
Absolutely! This is how most people would trade options...for the short term gain in the value of the option contract itself based on the movements in the underlying asset.
I'm not sure about your second question though. Can you elaborate?
Glen O'Riordan
May 8th, 2009 at 10:44am
Can you buy an option, let's say a call option, with no intention of exercising it, but rather merely the expectation of trading out of it? Can you take advantage of the leveraging situation without risking needing to actually pay for the stock - that is, if the stock moves into a profitable range, sell the option (rather than exercise it), and if not simply pay the premium. Is it possible that you would decide to sell the option and not be able to?
Admin
January 9th, 2009 at 6:14pm
Try http://www.nseoptions.com/
Bankim Majumder
January 8th, 2009 at 8:27am
Want to know whether any put in Indian stock market may buy currently i.e. within 14-01-2009
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