What are call and put options?
Professional investment portfolios tend to include several asset classes, such as equities or stocks, fixed income products such as bonds, cash, commodities and many more. A large variety to choose from, don’t you think so? Options are another asset class, which, if used correctly, can offer plenty of advantages.
An option is a derivative productive that, contractually, provides the opportunity (but not the obligation) to buy or sell an asset in the future at a specified strike price. Just like most other asset classes, options can be purchased with brokerage investment accounts.
There are two types of options: puts and calls. In every option transaction, there are two parties involved: the seller, also known as the ‘writer’, and the buyer. Call and put buyers take what is known as a long position, whereas call and put sellers take a short position. Each side participating in the trade comes with its own potential profits and risks.
What do puts and calls have in common?
However, despite their significant differences, the two still share some similarities:
- Sensitivity to a change in implied volatility. Expected volatility of the underlying asset, also known as implied volatility, has a great impact on the option’s price. Higher implied volatility leads to a higher price for both calls and puts.
- Usage for long and short positions. Both puts and calls can be traded in long and short positions.
- Usage for hedging. Puts and calls are commonly used for hedging purposes.
- Usage for speculating. Both types of options are heavily used for speculation by many traders.
- Value decay over time. Calls and puts are sensitive to the time expiration.
- Can be In the Money or Out of the Money. Puts and calls value can be defined by their moneyness.
What are the call and put options differences?
Now that we defined two main types of options and covered their similarities, it is time to move on to the differences between call and put options.
Additionally, when comparing call vs put options, it is crucial to keep in mind that they react differently to the changes in the environment they trade in:
- Changes in the underlying price. Puts are known to decrease in value with a positive change in an underlying asset, while the value of calls increase in the same situation. Conversely, put options increase in value with a negative change in the underlying price, whereas calls decrease.
- Changes in interest rates. Calls increase in value with higher interest rates, whereas puts decrease in value – and vice versa in case of lower interest rates.
- Proximity to the dividend date. Calls lose value as they get closer to the dividend date, meanwhile the value of puts increase.
Puts and calls can be a useful tool for both traders and investors, as they can offer protection, leverage and a possibility for a higher profit. As there is a variety of different trading techniques available, you have to be sure to do your research and pick a strategy that best suits your experience and goals. Professionals always recommend diversifying your options and incorporate both bullish and bearish strategies, as it will minimise the loss risk and increase your chances of having winning positions in your portfolio.
Find out more about options trading with our free online course and comprehensive glossary at Capital.com.