What are Options: Calls and Puts? (Part 2)

 What are Options: Calls and Puts? (Part 2)

An option is a derivative, a contract that gives the buyer the right, but not the obligation, to buy or sell the underlying asset by a certain date (expiration date) at a specified price (strike price). 

There are two types of options: calls and puts.

the strike price specified in the option contract. Investors buy calls when they believe the price of the underlying asset will increase and sell calls if they believe it will decrease.

2. Put options

Puts give the buyer the right, but not the obligation, to sell the underlying asset at the strike price specified in the contract. The writer (seller) of the put option is obligated to buy the asset if the put buyer exercises their option. Investors buy puts when they believe the price of the underlying asset will decrease and sell puts if they believe it will increase.

Payoffs for Options: Calls and Puts

Calls             

The buyer of a call option pays the option premium in full at the time of entering the contract. Afterward, the buyer enjoys a potential profit should the market move in his favor. There is no possibility of the option generating any further loss beyond the purchase price. This is one of the most attractive features of buying options. For a limited investment, the buyer secures unlimited profit potential with a known and strictly limited potential loss.

If the spot price of the underlying asset does not rise above the option strike price prior to the option’s expiration, then the investor loses the amount they paid for the option. 

However, if the price of the underlying asset does exceed the strike price, then the call buyer makes a profit. 

The amount of profit is the difference between the market price and the option’s strike price, multiplied by the incremental value of the underlying asset, minus the price paid for the option.

Selling Call Options

The call option seller’s downside is potentially unlimited. As the spot price of the underlying asset exceeds the strike price, the writer of the option incurs a loss accordingly (equal to the option buyer‘s profit). However, if the market price of the underlying asset does not go higher than the option strike price, then the option expires worthless. The option seller profits in the amount of the premium they received for the option.

Puts

A put option gives the buyer the right to sell the underlying asset at the option strike price. The profit the buyer makes on the option depends on the spot price of the underlying asset at the option’s expiration. If the spot price is below the strike price, then the put buyer is “in-the-money”. If the spot price remains higher than the strike price, the option expires un-exercised. The option buyer’s loss is, again, limited to the premium paid for the option.

The writer of the put is “out-of-the-money” if the spot price of the underlying asset is below the strike price of the contract. Their loss is equal to the put option buyer’s profit. If the spot price remains above the strike price of the contract, the option expires un-exercised and the writer pockets the option premium.

( To be continued..)