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.