Put, and Call is both types of options used to hedge against volatility in the market while also speculating on the underlying security or asset value. Options like Put and Call allow an investor to invest in a stock, bond, or asset without owning any of the said stock, bonds, or asset.
The options are a legal contract between the investor and the contract seller, such as a bank, that allows the investor to buy or sell an asset, stock, or bond at a fixed date in the future. Still, it does not obligate an investor to buy the underlying security.
Options are a great way to invest and speculate without exposing the investor to significant market risk.
What are Puts?
Puts are an option contract that allows an investor to sell the security, which is covered by the contract at the security’s current price at a future date written in the contract. Like all the options contracts, it does not obligate the investor to sell the security.
It is a financial tool used by investors when they believe that the price of a particular security will fall in the future. The investor looks to make money from the falling prices. It is also an excellent hedging tool against any market volatility.
Example of a put
Consider a stock A which is being priced today at ten dollars, but the investor believes it will fall to five-dollar in the future. So, an investor buys a put option on stock A for one dollar. Now, it is the future, and the stock has fallen to five dollars. The investor exercises the put contract and sells the stock A for ten dollars, subtracting the options contract price the investor made four dollars.
Now, consider the opposite scenario, what if stock A had risen five dollars instead of falling five dollars. The investor would have paid only one dollar for the put option contract. If, instead of using a put option, an investor had bought the stock outright, he/ she would be on the hook for five dollars instead of the one dollar the investor paid.
Thus, options contracts are a great way to reduce risk, as stated in the example above.
What are Calls?
Calls can be said to be the opposite side of the options contract. Instead of allowing the investor to sell the security underlined in the options contract, it allows the investor to buy the security underlined in the options contract at a future date expressed in the options contract.
The investors use the call option contract when they believe that the price of securities would go up, and they want to expose themselves against any gains in the market.
Example of a call contract
Let’s take the previous example of Stock A. But, instead of using the puts options contract, the investor uses the call option contract. The investor is doing that because he/ she believes that the price of Stock A would rise in the future. He/ she believes that the price of Stock A would rise from ten dollars to fifteen dollars. So, the investor buys an option call contract for one dollar.
The future data has come, and the price is exactly what the investor believed it would be, and the investor makes a profit of four dollars.
If Stock A’s price has gone in the opposite direction against the investors’ expectation, the investor would only be liable for one dollar and not a loss of five dollars if the investor had bought the stock outright.
It has been observed that call options are mainly used for stock speculation and when the numbers of call options rise, it signals a market mania.
Long traders mainly use call options. Long trading means that the investors believe the prices of stocks and bonds would rise in the future. Call options are an excellent way for long trading because you can expose yourself to a significant number of securities instead of just buying a few stocks. It significantly reduces risk while at the same time magnifying returns.
Short traders use put options as the primary tools for shorting securities. While short traders mainly find corrupt companies lying to their investors about their financial conditions, they also use options to short the stocks.
The short traders mainly use the put options to bet against the underlying market conditions.
Put options were also used by hedge funds that were shorting the stock of GameStop. This allowed them to short more stock of the company than the total issued stock of the company.
We also saw what happened to GameStop’s stock shorter. So, we should always be careful when using put options as the market conditions can sweep us away.
Characteristics of Put options
Following are the main characteristics of the put options:
i) Put options are used to sell the underlying security.
ii) It is also used for shorting the stock.
iii) The investor uses the put options to protect themselves against any market volatility.
iv) Risk is reduced when using the put options.
Characteristics of Call Options
The main characteristics of the Call options are as follows:
i) Call options are used to buy the underlying security in the future.
ii) It is used by the investors when they believe that the underlying security price would go up.
iii) It allows the investor for great exposure to a bulls market.
iv) It is also an excellent hedging tool against any risk.
The put and Call are two types of options. While they both do the same thing, the method of doing it is different. Put and Call are also great hedging tools against market volatility.