Are you trying to work out the difference between a call option and a put option? Both of these options are very useful tools for investors. Let’s start with their commonality, they are both options. Options are a particular type of derivative contract, meaning that their value is derived from an underlying asset. Put options and call options are, more or less, two sides of the same coin, but we’ll get into that later on in this article.
Options give people the right, but do not obligate them to buy assets at a specified price at or within a specified time. This means you can chose to buy assets but you will not be required to do so. This makes options very different from stocks, bonds, and commodities as you never actually take control of the asset in question. Instead, you are given a contract that affords you certain rights and obligations.
If you want to invest in options, it is essential to understand the nature of the contracts themselves. Why? Options expire and become worthless. Stocks, on the other hand, don’t expire (although companies can go bankrupt and stocks can be voided). Make sure you remember these risks if you decide to engage in options investing. Don’t mistake us, options are a great investment choice, but they do come with some unique risks. On the other hand, they also very high potential rewards.
Going Over An Option Example With Gold
Let’s say you want to buy gold options because you believe gold is primed for a big increase in price. You only have a small amount of money, say $500 dollars, so you can’t buy a lot of gold. You can, however, buy a good number of options.
Let’s say 30 day options to buy gold at $1100 dollars an ounce are selling for $20 dollars. In this case you can buy 25 options. Let’s assume that you do so. Then, let’s say the global economy is rocked. Perhaps President Trump made good on his promise to enact protectionist measures. Maybe China’s debt problems finally boiled over. Whatever.
As the economy is rocked by turbulence, investors flee to safe haven assets, such as gold. So suddenly gold prices skyrocket, reaching $1,500 hundred an ounce! If you had bought an ounce of gold, you would have made a very solid $400 dollar return. However, you invested in options, and were able to buy 25 of them.
Now, you can lock up the profit difference between your optional price, and the market price, in this case about $400 dollars per option! Add it all up and the returns are far more substantial! In fact, in this case you’ve earned roughly $10,000 dollars! As you can see, options are a very high reward type of investment.
If you’re insights had been proven wrong, however, you would have lost all of your investment.
So What is a Put Option? How About a Call Option?
So now that you know what options are, let’s dig into the differences between call and put options. Remember how we said they are two sides of the same coin? Let’s go over what exactly that means. Put options are options that allow you to sell an asset at a specified price. Call options, on the other hand, are like the example above, they allow you to buy at a certain price. This might seem like a nuance, but it is essential for understanding how options work and how you can make money off of them.
Put Vs. Call Option Illustrated in MSFT Example
Let’s take a put option and “put” it into an example. Let’s assume that you’re a portfolio manager for a major hedge fund. You’ve bought $10,000,000 dollars worth of Microsoft (MSFT) shares at $60 dollars a share. You’re confident that MSFT will rise because they are launching a hot new virtual reality technology, but you also know that the risks are high. So what can you do?
You can actually use put options to act as a form of insurance. Let’s say that Microsoft is going to launch their augmented reality software in 28 days, so you buy 30 day put options that will allow you to sell your MSFT shares at $60 dollars. If the technology is a flop and stocks do drop, then you’ll be able to exercise your options. Let’s say you pay $6 dollars an option.
Microsoft’s augmented reality software is released and it’s a smashing success. Suddenly MSFT is skyrocketing. Within 24 hours, MSFT is selling for more than $80 dollars a share. In this case, you’ll choose not to exercise your options and you’ll let them expire. You’ll lose the six dollars you paid per option, but even after subtracting the costs, you’ve profited $14 dollars per share on your Microsoft stock.
Investing in Call and Put Options
Call and put options are also often used as direct investments. Put and call options are also often used as insurance in the manner described above. What’s essential to remember with options is that they expire. If you don’t exercise your options within a given period of time, they will become literally worthless. This is true of both call and put options, and pretty much all other types of options.
As you can guess, there are a lot of options when it comes to options.