What are options?
To understand what put and call options are we need to briefly define what options are. This is necessary to cement our understanding of put and call options. Think about options as the right but not the obligation to buy or sell an amount of an asset at a certain price before the option expires. This essentially means that options allow you to choose to buy or sell without permission from the seller or purchaser. You do not have to go through with the trade if you ‘win’ the option. That is why it is a right and not an obligation.
If that sounds like a mouthful rest assured. It will become a lot clearer with the examples set out in this article. Check out our article on binary options to get a better understanding of other types of options available.
What are put options?
We mentioned binary options above and these involve a level of risk and speculation. Put options are different because instead of making profit they act as insurance mechanisms. A put option allows you to sell an asset that you have contracted for at a specified price. This price is regardless of how much lower the asset goes passed that point.
Think about put options as an insurance policy on a house. If damage occurs to the house, insurance covers it because you pay a premium for the insurance. That is part of the deal, you pay a premium and the insurance company pays for any damage. Put options work exactly in the same way. With put options you purchase an option and pay a premium for the asset you ‘insure’. If the asset price goes below the amount specified you can sell it for the insured price. The option provider has to purchase all the shares insured for at that price.
Put option example
Lets say you have 100 shares and they are currently going for $50 a share. If you want them to be insured you would go for a put option. Imagine the price specified in the option is $45 a share and it costs $1 per share for the insurance. If the share price goes from $50 to $30 in the specified period that the option is running for, you now have the right to sell your 100 shares for $45 to the options provider. Although you payed a premium of $1 per share costing in total $100, you saved $15 per share because you were able to sell at $45 instead of $30. When you calculate the cost of the premium with the amount of money it saves you by being able to sell at $45 instead of the market price of $30 it ends up saving $1400.
What are call options?
Call options are similar yet different to put options in the way that you pay a premium for the option. Instead of acting as an insurance policy, call options give you the right to purchase an asset in the future.
Going back to the home insurance analogy. Think about call options as placing a deposit to purchase a home in the future. Let’s say you paid $20k to reserve your right to purchase a home for $500k in the next five years. The reason you would maybe want to wait and reserve the option to purchase instead of just buying the home is because there could be potential development around the area and the price of the home would increase significantly if those developments are approved.
Let’s say that the developments did get approved. Because you have retained the right to buy it at a cheaper price despite paying a premium, you profit by now being able to purchase a more valuable home for less money.
In the event the developments were not approved then you only lose the premium and do not have to purchase the house. This is advantageous when the lack of developments would lower the value of the house by more than the premium paid. If the developments did not go through and the house drops in value to $450k you saved yourself $30k by not having to purchase it. For a more comprehensive guide on options click here.
Call option example
Imagine that you believe that the share price of a company is going to increase from $10 to $20 within three months. You purchase a call option for that value and pay a premium of $1 per share. Let’s say you want to buy 100 shares, so you end up paying $100 of premium in total. If the value goes to $20 you can now choose to purchase those 100 shares for $10 instead of $20. When you calculate the cost of the premium with the amount of money you make by purchasing the shares for $10 instead of $20 it equates to $900 in profit.
How to make sure that the options provider is legitimate
If you are concerned about the legitimacy of an options provider, you should search the provider through ASIC Connect’s Professional registers.
When you look through this register, make sure that the provider has an Australian financial services (AFS) licence, or is authorized by an AFS licensee.
Conclusion
Put and call options offer a way to both save and make money by lowering risk by paying a premium. Put options are similar to insurance policies that protect your investments particularly when it comes to shares. Call options allow you to make a considerable amount of money only risking the premium incase your prediction isn’t correct. As a reminder there are no guarantees with options trading. You should only be willing to put in as much as you are comfortable with losing. You should seek a lawyer if considering trading options to minimize risk and to make sure no complications arise from the options contract.
