This article is part 3 of the Futures & Options section of our Stock Market Learning series created by SMJ. Whether you’re new to options trading or looking to enhance your understanding, this guide will walk you through the basics of call and put options. We’ll explore how these powerful financial instruments work, when to use them, and how they can be a valuable addition to your trading strategy. Options offer flexibility and leverage in trading, but they come with unique risks, so it’s essential to understand the details before diving in.
Call and put options are essential financial derivatives that give investors the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified period. These options are widely used in the stock market for both speculation and hedging purposes. Unlike traditional investments like stocks or bonds, where ownership of the asset is involved, options contracts allow traders to profit from price movements without owning the asset itself.
Also Read: Understanding Futures and Options: Benefits, Risks, and Who Should Invest
There are two main types of options
- A call option gives the buyer the right to buy an asset at a specific price (known as the strike price) within a certain time frame.
- A put option gives the buyer the right to sell an asset at a specific price within a certain period.
Options trading is attractive because it offers the potential for significant profits while limiting risk to the premium paid for the option. Additionally, traders can use options to hedge against market volatility, ensuring they are protected if prices move against their positions.
Options can be further categorized into American-style options, which can be exercised at any time before their expiration date, and European-style options, which can only be exercised on the expiration date. In the Indian stock market, most options traded are of the American style.
Key Terms to Understand
- Underlying Asset – The stock, commodity, index, or security on which the option is based.
- Spot Price – The current price of the underlying asset.
- Strike Price – The price at which the option holder can buy (in a call) or sell (in a put) the underlying asset.
- Option Premium – The price paid by the buyer to the seller for the option.
- Expiration Date – The date by which the option must be exercised or it expires worthless.
- In-the-Money (ITM) – A situation where the option has intrinsic value (e.g., the stock price is above the strike price for a call option or below for a put option).
- Out-of-the-Money (OTM) – A situation where the option has no intrinsic value (e.g., the stock price is below the strike price for a call option or above for a put option).
- At-the-Money (ATM) – A call option is at-the-money when the current price of the underlying asset is exactly equal to the strike price.
Also Read: How to Start Options Trading in the Indian Market: A Beginner’s Guide
What is a Call Option?
A call option is a type of financial derivative that grants the buyer the right, but not the obligation, to buy an underlying asset—such as a stock, commodity, or index—at a predetermined price (called the strike price) before or on a specified expiration date. The buyer pays a premium for this right, and the potential for profit lies in the underlying asset’s price rising above the strike price.
Call options are widely used for speculation, allowing investors to profit from price increases without owning the actual asset. They are also used for hedging, where investors protect themselves against potential price increases in the market.
How Call Options Work
When you purchase a call option, you are buying the right to acquire an underlying asset at a set price (the strike price) within a defined period (up to the expiration date). If the asset’s price rises above the strike price, the call option can be exercised, allowing the buyer to purchase the asset at the lower, fixed price and potentially sell it at the higher market price, making a profit.
If the price of the underlying asset stays below the strike price by the expiration date, the call option expires worthless, and the buyer only loses the premium paid to acquire the option. In this scenario, the seller (or writer) of the call option keeps the premium as profit.
Example of a Call Option
Let’s say you believe the price of Company XYZ stock, which is currently trading at ₹400, will rise over the next month. You decide to buy a call option with a strike price of ₹420, paying a premium of ₹15 per share. Each option contract typically covers 100 shares, so your total investment (premium) is ₹1,500 (₹15 x 100 shares).
Scenario 1 – Stock Price Rises
By the expiration date, the stock price rises to ₹460 per share. You exercise your call option and purchase the stock at ₹420, then sell it at ₹460, earning a profit of ₹40 per share. After deducting the ₹15 premium, your net profit is ₹25 per share, or ₹2,500 (₹25 x 100 shares).
Scenario 2 – Stock Price Stays Below Strike Price
If the stock price stays below ₹420 (for example, ₹410), the option expires worthless, and you do not exercise your right to buy the stock. In this case, you lose only the premium you paid, which is ₹1,500.
When to Use a Call Option
- Speculation – Investors buy call options when they expect the price of the underlying asset to increase. This allows them to gain exposure to rising prices without the need to purchase the asset outright.
- Hedging – Call options can also be used as a hedge to protect against the risk of rising prices. For example, a business expecting to buy a large quantity of oil in the future may purchase call options on oil to lock in a price and protect itself from potential price increases.
Also Read: How to Do Futures Trading in the Indian Market: A Comprehensive Guide
What is a Put Option?
A put option is a financial contract that gives the buyer the right, but not the obligation, to sell an underlying asset—such as a stock, commodity, or index—at a predetermined price (called the strike price) before or on a specific expiration date. The buyer of a put option pays a premium for this right. Put options are typically used when an investor expects the price of the underlying asset to decline.
Put options allow investors to protect against falling prices or to speculate on a decline in the value of an asset. Just like call options, they can be used for both hedging and speculation.
How Put Options Work
When you purchase a put option, you acquire the right to sell the underlying asset at the strike price, regardless of the market price at the time of the sale. This means that if the price of the asset falls below the strike price, the put option becomes valuable, and the buyer can either sell the asset at the higher strike price or sell the option itself for a profit.
If the asset’s price remains above the strike price, the put option becomes worthless at expiration, and the buyer loses only the premium paid for the option. The seller (or writer) of the put option collects the premium but faces the obligation to buy the asset if the buyer decides to exercise the option.
Example of a Put Option
Let’s say you own shares of Company ABC, currently trading at ₹300 per share, but you believe that the price will fall over the next month. To protect yourself from a potential drop in value, you purchase a put option with a strike price of ₹280, paying a premium of ₹10 per share. Each option contract typically covers 100 shares, so your total investment (premium) is ₹1,000 (₹10 x 100 shares).
Scenario 1 – Stock Price Falls
If the stock price drops to ₹250 by the expiration date, you can exercise the put option and sell your shares at ₹280, even though the market price is lower. This results in a gain of ₹30 per share (₹280 ₹250). After subtracting the ₹10 premium, your net profit is ₹20 per share, or ₹2,000 for the 100 shares.
Scenario 2 – Stock Price Rises or Remains Stable
If the stock price stays above ₹280 (e.g., ₹310), the option expires worthless, and you lose only the ₹1,000 premium paid. In this case, you would not exercise the option, as you could sell the shares at the higher market price.
When to Use a Put Option
- Speculation – Put options are often used when investors believe the price of an asset will decrease. Buying a put option allows you to profit from a decline in the asset’s price without actually owning or shorting the asset itself.
- Hedging – Investors can use put options to hedge their existing positions. For example, if you own shares of a stock and are concerned about a potential price drop, buying a put option provides protection. If the stock price falls, the gains from the put option can offset the losses in the stock position.
Example of Hedging with a Put Option
Suppose you own shares of Company XYZ, which are currently trading at ₹500, but you are worried about a potential market downturn. To protect your position, you purchase a put option with a strike price of ₹480, paying a premium of ₹20.
Scenario 1 – Stock Price Falls
If the stock price drops to ₹450, your put option allows you to sell the shares at ₹480, protecting you from a significant loss. After accounting for the premium, your net loss is limited to ₹20 per share.
Scenario 2 – Stock Price Rises
If the stock price rises to ₹530, you do not need to exercise the put option, and your loss is limited to the ₹20 premium paid. The gains from the rising stock price will more than offset the premium loss.
Option Greeks
In options trading, Option Greeks are essential tools used to measure various risk factors that affect the price of an options contract. These metrics help traders analyze how different factors like time decay, volatility, and price changes in the underlying asset impact the value of both call and put options.
The five primary Option Greeks are Delta, Gamma, Theta, Vega, and Rho. Understanding these Greeks enables traders to make informed decisions and manage risk effectively in options trading.
Delta (Δ) – Sensitivity to Price Movements
Delta measures how much the price of an option is expected to change when the underlying asset’s price changes by ₹1. In other words, it shows the sensitivity of the option’s price to movements in the asset’s price.
- Call Option – Delta ranges from 0 to 1. A call option with a delta of 0.5 means that for every ₹1 increase in the asset’s price, the call option’s price will increase by ₹0.50.
- Put Option – Delta ranges from -1 to 0. A delta of0.5 for a put option indicates that for every ₹1 increase in the asset’s price, the price of the put option will decrease by ₹0.50.
Key Points
- At-the-money (ATM) options have a delta close to 0.5 for calls and0.5 for puts.
- In-the-money (ITM) call options have a delta closer to 1, and ITM put options have a delta closer to1.
- Out-of-the-money (OTM) options have deltas closer to 0 for both calls and puts.
Gamma (Γ) – Rate of Change in Delta
Gamma measures how much the Delta of an option changes when the underlying asset’s price changes. Essentially, it represents the acceleration of Delta and indicates how sensitive Delta is to price movements.
- High Gamma – Means that Delta will change quickly as the price of the underlying asset moves.
- Low Gamma – Indicates that Delta changes slowly, and the option’s price is less responsive to fluctuations in the asset’s price.
Key Points
- Gamma is highest for at-the-money options and decreases for both in-the-money and out-of-the-money options.
- Gamma is crucial for understanding how volatile an option’s price might become.
Theta (Θ) – Time Decay
Theta represents the rate at which an option’s price decays over time, all else being equal. It shows how much value an option loses each day as it approaches expiration, making it a vital metric for understanding time decay.
- Call and Put Options – Both types lose value as the expiration date nears. Theta is usually negative for both calls and puts, indicating that the option’s value declines with the passage of time.
Key Points
- Short-term options have higher Theta, meaning they lose value faster as they approach expiration.
- Long-term options decay more slowly.
- Theta works against option buyers and in favor of option sellers who benefit from time decay.
Vega (ν) – Sensitivity to Volatility
Vega measures how much an option’s price will change when there is a 1% change in the implied volatility of the underlying asset. Implied volatility refers to the market’s forecast of a likely movement in the asset’s price.
- Higher Vega – Means the option’s price is more sensitive to changes in volatility.
- Lower Vega – Indicates that the option’s price is less impacted by changes in volatility.
Key Points
- Options with longer expiration dates are more sensitive to volatility, leading to a higher Vega.
- Increased volatility generally raises the price of both call and put options, as greater uncertainty means higher risk and thus higher premiums.
Rho (ρ) – Sensitivity to Interest Rates
Rho measures how much an option’s price will change in response to a 1% change in interest rates. While not as commonly focused on as the other Greeks, Rho becomes more significant for options with longer expirations.
- Call Options – Rho is positive, meaning the value of a call option increases as interest rates rise.
- Put Options – Rho is negative, indicating the value of a put option decreases as interest rates rise.
Key Points
- Interest rate changes typically have a minor effect on short-term options but can have a more significant impact on long-term options.
How Option Greeks Work Together
The Option Greeks do not work in isolation. Instead, they interact to provide a comprehensive view of an option’s behavior in different market conditions. For example –
- Delta and Gamma help traders understand price movement sensitivity.
- Theta informs how much value the option will lose as time passes.
- Vega indicates how price volatility impacts the option’s premium.
- Rho provides insight into how interest rates may affect the option.
Call and Put Options for Beginners
When starting with options trading, understanding call options and put options is crucial. Both of these financial instruments allow investors to speculate on the future price movements of assets like stocks, indices, commodities, or currencies, without actually owning them. However, they work in different ways depending on whether you expect prices to rise or fall.
Call Option – A Bet on Rising Prices
A call option gives the buyer the right, but not the obligation, to buy the underlying asset at a specified price (called the strike price) before or on the expiration date. This type of option is ideal when you expect the price of the underlying asset to increase.
When to Use a Call Option
- Buy a Call Option – When you believe the price of the underlying asset will rise above the strike price before the option expires. For example, if you expect a company’s stock price to go up, you can buy a call option to benefit from that increase without purchasing the actual shares.
- Sell a Call Option – If you expect the price to stay below the strike price, selling a call option allows you to earn the premium from the buyer.
Example –
Let’s say you purchase a call option on a stock with a strike price of ₹500, and you pay a premium of ₹20 for this option. If the stock price rises to ₹550, you can exercise your right to buy the stock at ₹500, making a profit (minus the premium paid). However, if the stock price stays below ₹500, the option expires worthless, and your loss is limited to the ₹20 premium.
Put Option – A Bet on Falling Prices
A put option gives the buyer the right, but not the obligation, to sell the underlying asset at a specified strike price before or on the expiration date. This type of option is typically used when you expect the price of the underlying asset to decrease.
When to Use a Put Option –
- Buy a Put Option – When you expect the price of the underlying asset to drop below the strike price. For example, if you anticipate a decline in a stock’s value, buying a put option allows you to sell the stock at the higher strike price, making a profit from the price drop.
- Sell a Put Option – If you expect the price to rise or remain stable, selling a put option allows you to earn the premium from the buyer.
Example –
Suppose you buy a put option on a stock with a strike price of ₹300, and you pay a premium of ₹15. If the stock price falls to ₹250, you can exercise your right to sell at ₹300, profiting from the difference. However, if the stock price stays above ₹300, the option expires worthless, and your loss is limited to the premium paid.
Expiry Outcomes for Call and Put Options
When a call or put option reaches its expiration date, several outcomes can occur depending on the relationship between the strike price and the spot price (the current market price of the underlying asset). Understanding these expiry outcomes is essential for options traders to determine potential gains or losses.
Expiry Outcomes for Call Options
A call option gives the holder the right to buy the underlying asset at the strike price. At expiration, the value of the call option depends on the asset’s market price relative to the strike price.
In-the-Money (ITM) –
- Scenario – The spot price is higher than the strike price at expiration.
- Outcome – The option holder can exercise the call option and buy the underlying asset at the lower strike price. The difference between the spot price and the strike price, minus the premium paid, represents the profit for the buyer.
- Example – If you have a call option with a strike price of ₹500, and the stock is trading at ₹550 at expiration, your option is in-the-money. You can buy the stock at ₹500 and sell it at ₹550, earning ₹50 per share (minus the premium paid).
Out-of-the-Money (OTM) –
- Scenario – The spot price is lower than the strike price at expiration.
- Outcome – The call option expires worthless because there is no benefit to buying the underlying asset at the higher strike price. The buyer loses the premium paid for the option.
- Example – If you have a call option with a strike price of ₹500, and the stock is trading at ₹450 at expiration, your option is out-of-the-money. The option will expire worthless, and your loss is limited to the premium you paid.
At-the-Money (ATM) –
- Scenario – The spot price equals the strike price at expiration.
- Outcome – The option expires with no intrinsic value. The buyer has no profit or loss on the trade, but the loss is limited to the premium paid for the option.
- Example – If you hold a call option with a strike price of ₹500, and the stock is also trading at ₹500 on the expiration date, the option expires without value, and you lose only the premium paid.
Expiry Outcomes for Put Options
A put option gives the holder the right to sell the underlying asset at the strike price. At expiration, the value of the put option depends on the market price of the asset compared to the strike price.
In-the-Money (ITM) –
- Scenario – The spot price is lower than the strike price at expiration.
- Outcome – The option holder can sell the underlying asset at the higher strike price. The difference between the strike price and the spot price, minus the premium, is the profit for the buyer.
- Example – If you hold a put option with a strike price of ₹400, and the stock is trading at ₹350 at expiration, your option is in-the-money. You can sell the stock at ₹400 and buy it at ₹350, making a profit of ₹50 per share (minus the premium paid).
Out-of-the-Money (OTM) –
- Scenario – The spot price is higher than the strike price at expiration.
- Outcome – The put option expires worthless because there is no advantage in selling the asset at the lower strike price. The buyer loses the premium paid.
- Example – If you hold a put option with a strike price of ₹400, and the stock is trading at ₹450, your option is out-of-the-money. The option expires without value, and your loss is limited to the premium you paid for the option.
At-the-Money (ATM) –
- Scenario – The spot price equals the strike price at expiration.
- Outcome – The option expires with no intrinsic value. The buyer has no profit or loss, but loses the premium paid.
- Example – If you hold a put option with a strike price of ₹400, and the stock is trading at ₹400 on the expiration date, the option expires without value, and your loss is limited to the premium you paid.
Expiry Outcomes
| Option Type | In-the-Money (ITM) | Out-of-the-Money (OTM) | At-the-Money (ATM) |
| Call Option | Spot Price > Strike Price (Profit) | Spot Price < Strike Price (Loss = Premium) | Spot Price = Strike Price (Loss = Premium) |
| Put Option | Spot Price < Strike Price (Profit) | Spot Price > Strike Price (Loss = Premium) | Spot Price = Strike Price (Loss = Premium) |
The information provided in this article is for educational purposes only and should not be considered as financial or investment advice. Options trading involves significant risk and may not be suitable for all investors. Before trading options or any other financial instruments, it is important to conduct thorough research and consult with a qualified financial advisor. SMJ is not responsible for any losses incurred from trading activities or decisions made based on the information provided in this article.
