Options can seem confusing at first, especially when terms such as strike price, premium and expiry appear together. At their core, however, options are built around a simple idea: one side gets a right, while the other takes on an obligation.
The two main types are call and put options. A call gives the buyer the right to buy an underlying asset at a predetermined price, while a put gives the buyer the right to sell it. Understanding this difference makes it easier to follow how options work, what affects their value and the risks faced by buyers and sellers.
Key Takeaways
- Options are derivative contracts that give the buyer a right, but not an obligation, while the option seller takes on an obligation under the contract.
- A call option gives the buyer the right to buy the underlying asset at the strike price, while a put option gives the buyer the right to sell it.
- The option buyer pays a premium for this right, while the seller receives the premium in exchange for taking on the corresponding obligation.
- Option prices are influenced by factors such as the underlying asset price, strike price, time to expiry, volatility and prevailing interest rates.
- Options can be used for purposes such as hedging and taking a view on market movements, but derivatives involve significant risks and losses can be substantial.
Table of Contents
What are call and put options?
An option is a derivative contract whose value is linked to an underlying asset, such as a share, index, currency or commodity. It gives the buyer a right under the contract, but not an obligation to exercise that right. The buyer pays a premium, while the seller receives the premium and accepts the corresponding obligation.
The two basic types of options are:
- Call option: Gives the buyer the right to buy the underlying asset at the strike price, subject to the contract terms.
- Put option: Gives the buyer the right to sell the underlying asset at the strike price, subject to the contract terms.
A call buyer may take the view that the price of the underlying asset could rise. A put buyer may expect the price to decline or may use the put to manage downside risk on an existing holding.
The seller takes the other side of the contract. A call seller may be required to sell or settle the contract if the call finishes in the money, while a put seller may be required to buy or settle the contract if the put finishes in the money.
Important terms used in call and put options
Before comparing calls and puts, it helps to understand a few terms that appear regularly in options trading:
Underlying asset
The underlying asset is the security, index, commodity, currency or other instrument from which the option derives its value. For example, a stock-option contract derives its value from the price of the relevant stock.
Strike price
The strike price is the predetermined price at which the option buyer has the contractual right to buy or sell the underlying asset.
For a call, the strike price is the price at which the buyer has the right to buy. For a put, it is the price at which the buyer has the right to sell.
Option premium
The option premium is the price paid by the buyer to acquire the option contract. The seller receives this premium in return for accepting the obligation under the contract.
For the buyer, the premium paid is generally the maximum potential loss if the option is allowed to expire without intrinsic value. For a standalone option seller, the premium received is generally the maximum potential gain before transaction costs.
Expiry date
The expiry date is the date on which the option contract ends. After expiry, the option can no longer be traded or exercised.
The expiry schedule and settlement process depend on the underlying asset, the exchange and the contract specifications.
In the money, at the money and out of the money
These terms describe the relationship between the underlying asset’s price and the option’s strike price:
- In the money: The option has intrinsic value.
- At the money: The underlying price is at or close to the strike price.
- Out of the money: The option does not have intrinsic value.
A call is in the money when the underlying price is above the strike price. A put is in the money when the underlying price is below the strike price.
What is a call option?
A call option is a derivative contract that gives the buyer the right, but not the obligation, to buy an underlying asset at a predetermined strike price within the contract period. The underlying asset may be a share, market index, currency or commodity.
The buyer pays a premium for this right, while the seller, also known as the option writer, accepts the corresponding obligation. The buyer may close the position, exercise the option where permitted, or allow it to expire, depending on the contract terms.
How does a call option work?
A call option gives the buyer the right, but not the obligation, to buy the underlying asset at the strike price before or at expiry, depending on the contract terms. A trader may buy a call when they expect the market price to rise.
If the market price moves above the strike price, the option may gain intrinsic value. However, the buyer’s position does not necessarily become profitable as soon as this happens. The rise must also be sufficient to cover the premium paid and any transaction costs.
If the market price remains at or below the strike price at expiry, the option may expire without intrinsic value. In that case, the buyer’s potential loss is generally limited to the premium paid.
The call seller receives the premium and takes on the corresponding obligation under the contract. If the underlying price rises sharply, the seller may face a loss that is larger than the premium received.
Example of a call option
Suppose Rohan expects a share currently priced at ₹100 to rise. He buys a call option with a strike price of ₹105 and pays a premium of ₹4 per unit. If the share price rises to ₹115 at expiry:
Intrinsic value = ₹115 – ₹105 = ₹10
After deducting the premium:
Potential net payoff = ₹10 – ₹4 = ₹6 per unit
If the share price remains at or below ₹105, the option would expire without intrinsic value. In that case, Rohan’s potential loss would generally be limited to the ₹4 premium paid, before transaction costs.
The figures shown are for illustrative purpose only.
What is a put option?
A put option gives its buyer the right, but not the obligation, to sell the underlying asset at the strike price under the terms of the contract. A put buyer may expect the price of the underlying asset to decline. A put may also be used to manage the potential downside risk associated with an existing holding. The buyer pays the premium, while the put seller receives the premium and accepts the corresponding contractual obligation.
How does a put option work?
A put option gives the buyer the right to sell the underlying asset at the strike price before or at expiry, depending on the contract terms. It generally gains intrinsic value when the market price falls below the strike price. If the price remains at or above the strike price at expiry, the option may expire without intrinsic value, and the buyer’s potential loss is usually limited to the premium paid.
Example of a put option
Suppose Aisha expects a share currently priced at ₹100 to fall. She buys a put option with a strike price of ₹95 and pays a premium of ₹3 per unit. If the share price falls to ₹85 at expiry:
Intrinsic value = ₹95 – ₹85 = ₹10
After deducting the premium:
Potential net payoff = ₹10 – ₹3 = ₹7 per unit
If the share price remains at or above ₹95, the put option would expire without intrinsic value. In that case, Aisha’s potential loss would generally be limited to the ₹3 premium paid, before transaction costs.
The figures shown are for illustrative purpose only.
Difference between call and put options
While both are option contracts, calls and puts provide different rights to their buyers:
| Basis | Call option | Put option |
| Right of the buyer | Right to buy the underlying asset | Right to sell the underlying asset |
| General market view of the buyer | The underlying price may rise | The underlying price may fall |
| Obligation of the seller | To sell or settle as per the contract | To buy or settle as per the contract |
| Intrinsic value at expiry | When the underlying price is above the strike price | When the underlying price is below the strike price |
| Maximum potential loss for the buyer | Generally limited to the premium paid | Generally limited to the premium paid |
| Maximum potential gain for a standalone seller | Generally limited to the premium received | Generally limited to the premium received |
| Potential risk for an uncovered seller | Theoretically unlimited if the underlying price continues rising | Substantial if the underlying price falls sharply |
| Possible use | Taking a view on a price rise or structuring a hedge | Taking a view on a price fall or managing downside risk |
The actual payoff also depends on the premium, contract size, transaction costs, settlement rules and the price at which the position is closed or settled.
What does selling a call or put option involve?
An option seller, also known as an option writer, receives the premium and accepts the obligation under the contract. The final outcome depends on the movement of the underlying asset, the strike price, volatility, time to expiry, transaction costs and settlement terms.
Selling a call option
A call seller generally expects the underlying price to remain below the strike price or not rise substantially before expiry.
A call can be sold in two ways:
- Uncovered call: The seller does not hold the underlying asset or another position that limits the risk. If the price rises sharply, the potential loss can theoretically be unlimited.
- Covered call: The seller owns the underlying asset while selling the call. This reduces the delivery risk, although downside risk remains and potential gains may be limited above the strike price.
Selling a put option
A put seller generally expects the underlying price to remain above the strike price or not fall substantially before expiry. If the put finishes in the money, the seller may have a settlement obligation.
For physically settled stock options on the NSE, the seller may need to take delivery of the shares. Index options are generally cash settled, so they do not result in the purchase of the underlying index constituents.
What are the risks of selling options?
The risks of selling options depend on the type of contract, the underlying asset and whether the position is covered, hedged or uncovered:
Potential for substantial losses
An uncovered call can result in theoretically unlimited losses because the underlying price has no fixed upper limit. An uncovered put can also lead to a substantial loss if the underlying asset falls sharply.
Limited maximum potential gain
For a standalone short call or put, the maximum potential gain is generally limited to the premium received before costs. The potential loss, however, can be considerably higher.
Margin requirements
Option sellers are generally required to maintain margin. If the position moves unfavourably, additional margin may be needed, and a shortfall could lead the broker to reduce or close the position.
Volatility risk
A rise in implied volatility may increase the option premium even when the underlying price has not moved significantly. This can create a mark-to-market loss for a seller who wants to close the position before expiry.
Assignment and settlement risk
An in-the-money option may be exercised at expiry. Depending on whether the contract is cash settled or physically settled, the seller may need to settle the amount in cash or deliver or receive the underlying shares.
Liquidity and execution risk
Options with low trading activity or wide bid-ask spreads may be harder or more expensive to exit. In a fast-moving market, the final execution price may also differ from the expected price.
Gap risk
A market-moving event may cause the underlying asset to open sharply higher or lower. This can change the option premium and margin requirement before the seller has an opportunity to adjust the position.
Time-sensitive risk
Time value generally declines as expiry approaches. However, even a small movement in the underlying price near expiry can lead to a sharp change in the option’s value and payoff.
Common strategies involving option selling
Option selling may be used as part of a broader strategy rather than as a standalone uncovered position. Each approach combines risk and potential reward differently:
Covered call
A covered call involves owning the underlying shares and selling a call option against them. The premium received may partly offset a fall in the share price, but it does not remove downside risk. Potential gains may also be limited if the price rises above the strike price.
Cash-secured put
A cash-secured put involves selling a put while keeping enough funds available to buy the shares if a physically settled option is assigned. The premium may reduce the effective purchase cost, but the position can still result in a loss if the share price falls sharply.
Credit spread
A credit spread generally involves selling one option and buying another of the same type, with the same underlying asset and expiry but a different strike price. The purchased option helps limit the potential loss, while the maximum potential gain is generally limited to the net premium received before costs.
Iron condor
An iron condor combines a put credit spread and a call credit spread. It is generally used when the underlying price is expected to remain within a certain range until expiry. The potential loss may be limited, but a sharp price movement can still result in a loss.
Factors that affect option premiums
An option premium can change for several reasons. The price of the underlying asset is one factor, but time, volatility, the strike price and even interest rates can also play a role:
Price of the underlying asset
When the price of the underlying asset rises, a call option’s premium generally increases, while a put option’s premium may fall. If the underlying price declines, the opposite may happen, provided other factors remain unchanged.
Strike price
The strike price is the price at which the option can be exercised. Its relationship with the current market price determines whether the option is in the money, at the money or out of the money. This relationship, known as moneyness, affects the option’s intrinsic value and premium.
Time remaining until expiry
Options with more time left until expiry generally carry a higher time value because there is more opportunity for the underlying price to move. As the expiry date gets closer, this time value usually falls. This gradual reduction is known as time decay.
Volatility
Volatility reflects how much the price of the underlying asset is expected to move. When expected volatility rises, both call and put premiums may increase because larger price movements become more likely. When volatility falls, premiums may also decline, provided other factors remain unchanged.
Interest rates and dividends
Interest rates and expected dividends can also influence option premiums. Their impact is usually less noticeable than price movements, time and volatility, but they are still considered when options are priced.
Conclusion
Call and put options can be used to take a market view, manage risk or build more complex strategies. However, the buyer and seller face very different payoff structures. While the buyer’s potential loss is generally limited to the premium paid, the seller may face a much larger loss depending on market movements, volatility and settlement conditions. Understanding these risks can make it easier to assess how an options position may behave before taking one.
FAQs
What do call and put options mean?
A call option gives the buyer the right, but not the obligation, to buy an underlying asset at a fixed strike price. A put option gives the buyer the right, but not the obligation, to sell it at the strike price. Simply put, put and call option means the right to sell and the right to buy, respectively.
Is call put option a separate type of option?
No. Call put option is not a separate type of contract. It is a commonly used search phrase referring to the two main types of options: call options and put options.
Put option v call option: What is the main difference?
In a put option v call option comparison, the key difference is the right given to the buyer. A call gives the right to buy the underlying asset, while a put gives the right to sell it. A call has intrinsic value when the underlying price is above the strike price. A put has intrinsic value when the underlying price is below the strike price.
Can an option seller lose more than the premium received?
Yes. An option seller’s maximum potential gain is generally limited to the premium received, but the potential loss can be much higher. An uncovered call can have theoretically unlimited loss potential. An uncovered put can also lead to a substantial loss if the underlying asset falls sharply.
Does an option seller always keep the premium?
The seller receives the premium when the option is sold, but it may not represent the final profit. If the option moves against the seller, the loss from closing or settling the position may partly or fully offset the premium and could exceed it.
Is selling a covered call free from risk?
No. A covered call reduces the delivery risk because the seller already owns the underlying shares, but it does not remove market risk. The share price may still fall, while gains may be limited if the price rises above the call option’s strike price.
Is selling a put the same as placing an order to buy shares?
No. Selling a put creates a contractual obligation, not a regular purchase order. For physically settled stock options, the seller may have to take delivery of the shares if the option finishes in the money at expiry. Index put options are generally cash settled and do not result in the purchase of index constituents.
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