2 Types of Equity Options: Call Options and Put Options

Defining the two types of options, calls and puts

Jun 26, 2015 at 3:17 PM
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Last week, we took a look at 3 Keys to Successful Contrarian Trading. This week, we are going to continue our educational series by taking a look at the two different types of options.

First things first, let's define an option. An option is a contract that give the investor the right -- not the obligation -- to buy or sell a set amount of an underlying security at a predetermined price (the strike) and by a predetermined date (expiration). Typically, an option contract represents 100 shares of an underlying stock and is priced on a per-share basis. Therefore, you may see an option on stock XYZ at $2. This means that the option will cost $200, as it gives the buyer the right to purchase (or sell) 100 shares of XYZ at a set price. 

With that simple definition out of the way, let's take a look at the two types of options: calls and puts. A call is an option contract that gives the buyer (also known as the holder) the right to purchase the underlying stock at the strike price on or before the expiration date of the contract. Generally, a call buyer is bullish toward the underlying stock, believing it will surpass the strike price by options expiration.

So, let's say you're bullish on XYZ, which is trading at $50. You might buy the August 55 call, expecting the shares to surmount $55 (the strike) by the time August options expire. If the stock does move north of the strike, the call will be in the money, and you could exercise your option. In other words, you could buy 100 shares of XYZ at $55 apiece -- a discount to what you'd pay on the Street. (And, of course, this isn't including what you originally paid for the option or brokerage fees.)

On the other hand, if you didn't want to own those XYZ shares, you could sell to close the call before it expires, capitalizing on the gain in premium. For instance, if your August 55 call was purchased for $2 and it jumped to $5 within the option's lifetime, you could sell it to close and pocket $3 ($5 minus premium paid), excluding fees.

As stated, a call buyer is generally bullish toward the underlying stock – but what if the investor is bearish? That's where put options come in. A put is an option contract that gives the buyer the right to sell the stock at a given strike price on or before the expiration date of the contract. 

Going back to XYZ, let's say you're bearish. The stock is still trading around $50, and you decide to buy the August 45 put. The put will move into the money if XYZ breaches $45 by August expiration. If the stock moves in your favor, you could exercise the put and sell 100 shares of XYZ at $45 apiece -- a premium to what you'd get on the Street.

Again, though, if your put is in the money and worth more than you paid, you could sell to close the option for a profit (excluding those fees and commissions).

We are going to take a deeper look ways to play puts and calls in the coming weeks, make sure to check back and learn more about option basics. Remember, you can always take advantage of our Getting Started with Options home-study program -- click here for more information.



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