Call and put options can be used to maximise profits or limit downside risk, having become some of the most popular types of derivatives available to investors. But what exactly are they, and how do they work?
Buying a call option
Buying a call option represents an opportunity to purchase an underlying share rather than the obligation to do so. A ‘long-call’ contract gives the holder the right to buy a share at a given price and within a fixed time frame.
For example, suppose an option contract gives the holder the right to buy 100 shares of ABC Biotech at a price of £170 until 30 September 2017, and assume the shares are currently trading at £160 as at 30 April 2017. The price of the option might be £5 per share, so £50 per option (100 shares).
Provided the share price rises above the ‘strike’ price of £170 at some point before the contract expiry on 30 September, there is potential for us to make a profit from the position, subject to the cost of buying the contract itself.
If we were to buy 10 such option contracts, covering 1,000 shares, on 30 April, it would cost £5,000. If the share price rises to £180 on 8 August our call options are now worth £10 a share or £10,000 and we can sell them for that. We have made £5,000 in profit.
In this example, we´ve made a 100% profit in a little over three months. We started with £5,000 but now we have £10,000.
If we’d invested the same amount of money in the actual shares at the original price of £160, rather than the options contracts, our return would have been much smaller. Our £5,000 would have bought 31 shares at £160 and seen them rise by £20 each, or £620 from a £5,000 investment.
Using a long-call option has therefore greatly boosted our profits versus conventional investing.
Buying a put option
While buying a call option enables us to profit when the share price rises above a certain level, acquiring a put option can allow us to benefit when the share price falls below a given level.
As such, put options are often used to hedge downside risk in portfolios. They act as a counterweight to long positions as they can provide some cheer when share prices fall.
Just as with buying a call option, the potential losses are limited to the amount paid for the contract at initiation. However, while long-call options offer limitless profits potential, there is a cap on the profit from buying put options. This is intuitive as ABC´s share price cannot fall below zero.
As stock markets tend to rise over time, the overall odds are modestly more in favour of the long-call holder than the long-put holder.
So what’s the catch?
Frequently, options expire ‘out of the money’ or worthless. In our long-call position, suppose the ABC share price had simply treaded water, staying in a tight range and below our £170 strike price.
As long-call holders we would have lost the £5,000 outlay entirely. In contrast, the conventional long investor could be in a better position in this case, as they could potentially hold onto the shares for a longer period time, beyond the point of call expiry until they reach their profit target.
The conventional investor could have also decided to sell at least some of their holding for a small profit, had the share price stayed below the £170 strike price but risen above the initial £160 opening level.
In the money
As our example of the ‘in the money’ call option suggests, buying such options can greatly increase our potential profits. However, the probability of such positions making us money can typically be just 25%, with the estimated probability determined by a function of the volatility of the option and the length of the contract.
The higher both these factors are, the more likely it is that the strike price on the long-put contract will be reached.
However, the cost of contracts on stocks with higher volatility will also be greater. Therefore, choosing contracts on stocks with lower volatility but which hold strong potential for share price movement due to upcoming corporate events could often prove to be better value.
We can also position ourselves on the opposite side of the table, and become the ‘writer’ of the contract offered to the buyer of the call or put. In this way, we would effectively become the seller of the contracts.
Taking the opposite side of the trade, we greatly increase our probability of success (75% versus the 25%) but reduce our potential profits.
As the writer of a call option, just as we noted the call option buyer´s gains are theoretically unlimited, so are our potential losses in the case of a ‘naked’ or ‘uncovered’ call writing position (the writer does not own the underlying stock so is completely exposed).
In comparison, risk is greatly reduced in the case of ‘covered’ call writing, which refers to writing call contracts on stocks held by your portfolio to generate additional investment income.
In this case, your conventional portfolio holding would counterbalance the risk of writing a call on a stock that rises very strongly.
Optionality provides investors with a diverse range of possible trading strategies that differ greatly in terms of their risk and reward profiles.
If used responsibly, options can add value to conventional investment strategies, providing ways to increase profits, generate additional income and limit downside risk.
Writing call options will not be for everyone, especially when the losses are unlimited.
However, as the buyer of an option, the great thing to know is that our losses are always capped at the premium we pay for the contract. In the case of the buyer of a call option, potential profits are also unlimited.